Written by Peter Carvill
The current state of the equity market means the time should be right to implement an unconstrained investment approach, Peter Carvill finds
Some of those reporting on the equity volatility at the beginning of this year saw nothing out of the ordinary in the markets’ behaviours. One, Vanguard’s Recent Stock Market Volatility: Extraordinary or ‘Ordinary’?, published in January, said: “To be sure, the 2000s have so far witnessed two severe bear markets and an extreme level of volatility and risk during the global financial crisis, yet it’s important to note that between 2003 and 2007, stock market volatility and risk aversion were at all-time lows historically. And when we compared the first decade of the 2000s and 2011 with long-term history, it’s clear that the data does not support the theory.”
Others, however, have disagreed. The Telegraph reported – using information and analysis from HSBC Global Asset Management – that these fluctuations have happened more frequently in recent decades. The Telegraph claimed that the FTSE 100 index of Britain’s biggest shares had seen its volatility increase five-fold in just a decade, and pointed to Standard & Poor’s 500 Index which swung by 3 per cent on just 15 days during the nineties, but 125 days during the noughties.
Regardless of whether the turmoil is normal or not, the tail-end of 2011 and the beginning of 2012 saw the equity markets go through a tumultuous period.
“What we saw in January,” says Vontobel’s head of UK and Ireland business Andrew Raisman, “was a market rally that began in December after a very difficult 2011. The US equity market held up pretty well but the emerging markets and other parts of the world didn’t do so well. The January rally was consolidated in February, and then we saw markets fall from there. This, essentially, was the volatility; the retrenchment was again driven by huge uncertainty in the global economy, a slowdown in China, and the continued difficulties in Europe.”
Mercer’s equity boutique global leader Deb Clarke fleshes out the circumstances of the volatility. She says: “A lot of this started in 2008. What you’ve had since is generally higher volatility in the market at the stock and sector levels. That’s led to a market that’s alternately been ‘risk on’ or ‘risk off’. ‘Risk on’ is when markets suddenly say that they like risk, usually because people think the problems are over and that there’s no issue. ‘Risk off’ is when everyone becomes concerned with risk and starts selling anything that carries it or has a long duration. People think that their earnings are a long way into the future and they want short-term money.”
The volatility has led some to predict some sort of wholesale return to unconstrained equity investing, which is when investments are made on their individual poten-tial and are not beholden to a benchmark.
Such a move would represent a shift back to an earlier state Fidelity’s Benchmarking and the Road to Unconstrained states: “Since the 1980s, market-capitalisation bench-marks have become the de facto standard in the investment industry, providing an anchoring point for investment portfolio managers and a means of measuring their performance. Increasingly, however, questions are being raised as to whether these benchmarks are resulting in undesirable outcomes. Market capitalisation indices may, for example, be part of the problem in terms of the pronounced bubbles and bursts we are experiencing.”
Raisman supports this view. “Ten years ago,” he says, “there was passive investing and somewhat limited active investing, with managers always referring back to the benchmark and looking to outperform by 1 or 2 per cent. Tracking was the one thing that these people talked about, along with relative weighting to the benchmark. A lot of those strategies didn’t do well, particularly after fees. And the constraints that clients and managers were putting on themselves were not creating added value for clients.”
Newton’s head of business development John Burke outlines the rise of benchmark investing.
He says: “It gathered pace during the ‘Great Moderation’, which conditioned many investors to expect strong and smooth returns from financial assets. Those days are now over. A consequence of the Great Moderation period was the massive build-up of developed world debt. The situation is unsustainable, as we are seeing in peripheral Europe, and deleveraging is a vital necessity.”
Benchmarking and the Road to Unconstrained outlines the benefits for funds in switching to uncon-strained equity investing such as that “risk is considered without reference to the benchmark. Instead, risk measures such as the absolute volatility of the fund and the contri-bution that each individual holding makes to the fund’s volatility are used. In this way, the portfolio can be constructed to achieve a mix of stocks which delivers lower volatility without lowering expected returns.”
Furthermore, says Burke, market indices are volatile and impacted by investors’ ‘flights to safety’. “These uncertainties and sudden movements,” he adds, “are also amplified by the fact that some markets (and therefore their indices) are dominated by a handful of companies – if one of the largest companies in the index is a victim of widespread investor sales, the index will suffer a significant negative impact. If your investment strategy is bound to an index, there is little option to shelter from such events – you are largely beholden to market whims. If, by contrast, you have the flexibility to ignore market indices and focus instead upon stock characteristics that are best suited to your long-term objectives and to weather current economic challenges, you should be better-placed to remain faithful to your long-term strategy, and to make defensive decisions to protect your portfolio along the way.”
However, Benchmarking also acknowledges the challenges. “An unconstrained manager is as much a manager of risk as a manager of returns. Each stock in the portfolio needs to pass either an explicit hurdle on returns or it needs to play a role in ensuring sufficient diversification. And in an investment world when most conventional metrics for monitoring portfolios are on a relative basis, the challenge is how to recalibrate existing systems and thought processes into an absolute mind set.”
Both Clarke and Raisman agree that the industry has moved more towards an unconstrained model in recent years. But where Clarke believes that the shift began in 2008 with the financial crisis, Raisman believes that its roots are much deeper, saying that the shift’s genesis goes back six years earlier. “There’s been a trend in the last decade,” he says, “of many, many more managers in large institutional fund management houses – and also smaller boutiques – setting themselves up to look at and develop much more unconstrained styles of investing where they are let off the leash a little so they can go out and look for the best possible ideas while being less concerned about tracking error but more focused on long-term performance and volatility.”
All this, however, has taken place against a backdrop of reduced equity investment. Research published by Mercer in its European Asset Allocation Survey indicated that British and Irish schemes have seen the biggest falls in equity allocations, with falls from 50 per cent to 44 per cent in Ireland over the last year, itself part of a 20 per cent fall since 2008. In the UK, investment over 12 months fell from 47 per cent to 43 per cent. That trend, Mercer predicted in August, is set to continue.
However, according to Raisman, the volatility at the start of the year has not directly persuaded many to move into unconstrained investing. “I’m not convinced,” he says, “when looking at the institutional equity space, that such short-term volatility would have too great an impact on sentiment towards unconstrained investing as an idea.” He adds: “It’s a trend that’s been going on for some time, and I’ve not seen anything that suggests that the volatility from earlier this year has altered that in any way.”
Written by Peter Carvill, a freelance journalist