Equity market cross-sectional volatility is at or near all-time lows, yet volatility shocks have never been more frequent, nor more severe. An Investment Magazine roundtable, sponsored by Northern Trust Asset Management, has heard that a combination of factors poses an unusual set of challenges for investors.
As long-term investors, superannuation funds are well-placed in being able to ride out volatility shocks. But that is not to say that the changing nature of risk can be ignored or that it is not challenging, and nor can funds overlook the importance of dealing with periods of volatility while continuing to meet their obligations to members.
Member behaviour forms a slightly unpredictable overlay, namely, the switch to more conservative investment options when markets get rocky, which can place liquidity demands on funds at the worst possible time.
But even taking the human nature element out of the investment challenge, Northern Trust AM deputy CIO and CIO of global equities Michael Hunstad told the roundtable that there is “something going on under the hood of financial markets that’s causing a very, very different risk regime today than we’ve had in the past”.
Hunstad said a “volatility shock” is when the VIX index goes up five points or more in a single day, and in the decade prior to the Global Financial Crisis, that had only ever happened five times.
“Since the Global Financial Crisis there’s been more than 70 days in which that occurred; also, the severity of those shocks has increased as well,” he said.
Hunstad said “microstructural issues” causing volatility include a significant shift in institutional investment from active to passive strategies, which leads to smaller, actively driven flows into or out of markets having an exaggerated effect on prices.
A shift to passive
Two decades ago, as much as 95 per cent of institutional assets were actively managed and around 5 per cent passively, so “95 per cent of assets had analysts worrying about valuation multiples and cash flows and profitability”, he said.
Today, however, just 45 per cent of institutional assets are actively managed, meaning that more than half of institutional assets are “sitting on the sidelines and, I argue, not participating in price discovery”, Hunstad said.
“Somebody’s got to set the price, and if it’s not an institutional, professional analyst, then it almost necessarily has to be more of a retail-oriented market participant,” Hunstad said.
“And you see a direct correlation between the rise of ETF assets, ETF flows, and these volatility shocks that occur in markets.
“The best explanation for this, once you dive into the numbers, is pretty obvious: equity markets in general have become more inelastic, meaning it takes a smaller dollar amount of flow to influence price. If you want to move the price 1 per cent, it takes about half the flow that it used to.”
Hunstad says increased retail investor influence means “more animal spirits, more emotions in markets”. For institutional investors, it means the level of risk in portfolios hasn’t necessarily increased, but tail risk has.
“What we have to think about [now is that] when things go bad, they can go really bad,” he says.
“The amount of tail risk may have big implications for asset allocation and how we think about total portfolio construction.”
While all of this is going on, “the volatility of fixed income has increased markedly, the correlation between equity and fixed income has increased markedly,” he said.
“Your traditional lever of dealing with higher tail risk in equities…in the past was [to] allocate out of equities into fixed income, but that may not necessarily be the right way to do it today.”
Hunstad says low correlations between individual stocks mean equity markets appear to be “very low risk right now”.
“But that’s all predicated on that correlation – and the fastest thing to change is a correlation,” he says.
If you think that we have actually slightly higher individual stock volatilities [and] lower correlations, at least for now, [if] that changes and goes up, all of a sudden we have potentially a volatility storm occurring in equity markets.”
Planning for the unexpected
Colonial First State chief investment officer Jonathan Armitage says asset owners are becoming increasingly sophisticated at scenario planning and stress-testing portfolios for unexpected volatility. Some systems to help them do this can be bought off-the-shelf, but “they generally tend to be focused on the things that have happened, not the things that might happen”, he said.
“Some of the things we’re starting to think about [are] what happens if you’ve got a very sharp 200-basis-point move in the 10-year [bond yield]?” Armitage said.
“Irrespective of what you might think the driver is, let’s say that that happened within a two-to-four-week period. What does that do? We all know it’s not good news, but how bad is it?
“And therefore, are there some things that you might want to do to ameliorate the impact of that, in terms of portfolio construction? That’s some of the things that we’ve done and are turning our minds to a lot more.
“Rather than ascribing a probability to it [we say] we don’t think the probability is zero, so let’s do some work and understand it, and then are there some ways that we could construct a portfolio that would produce a less-worse outcome?”
REST head of research and portfolio construction Paul Docherty said the fund thinks about the management of volatility through two lenses: a portfolio construction lens, “and then there’s an instrument lens”.
“[Through] the portfolio construction lens, it comes back to [the fact] that in our default strategy, 60 per cent of the allocation is in equities, but 90-odd per cent of the contribution to volatility comes from equity risk.
“So really, we’re talking about constructing a portfolio with diversifies that equity risk, but also with the view that we can’t just assume stable correlations with respect to what those diversifiers might look like.”
In these circumstances, Docherty said, a simple 40 per cent exposure to bonds isn’t up to the task.
“That’s why we look to construct a portfolio with a range of alternative diversifiers that provide protection across multiple alternative scenarios – areas like infrastructure, obviously, provide good contracted stable cash flows, often with inflation-linked characteristics, so can provide some of that support.”
Widening the range of instruments
Docherty said REST has been on “an internalisation journey” over the past four years and “widening the instruments that we’ve got available to us has been a really important project we’ve been working on”.
He says the fund has been “building internal trading desks and internal capabilities to enable us to be closer to the market, because we just didn’t have access to those instruments previously”
“But it also means it’s broader than just saying, great, we’ve now got access to put options so let’s throw a bunch of put options in the portfolio.”
Docherty says the fund doesn’t adopt an always-on protection strategy for its portfolio because of the cost, and the impact on the account balances of members of REST in particular, who have a lower average balance relative to the industry as a whole, is simply too great.
ART senior portfolio manager, investment strategy, Zoe McHugh says a bigger risk for fund members than investment risk per se is the risk they’ll retire with less than they need to live on comfortably. That means funds do need to expose members to risk – ART has recently migrated a significant number of members who have not exercised choice into a higher-risk and, therefore, higher-volatility option.
McHugh says there is “a wide range of tools” the fund uses to manage volatility, and it also takes advantage of being a long-term investor.
“Within equities, for example, we’ve always taken a multi-factor approach, by which I mean we’ll allocate a large amount to passive equities across both Aussie and developed markets because we believe in the equity risk premium, and we have time,” she says.
“Within fixed income, one of the benefits of the merger [of QSuper and Sunsuper] has been we’re able to allocate to duration in a more capital-efficient way. We’ve been able to take that physical allocation, and now, achieving the sort of the same level of duration as before, we can allocate that to more opportunistic strategies as we think they emerge. That doesn’t have to be a standard part of the portfolio.
“And then unlisted markets have obviously been a large feature of the heritage organisations and of ART going forward. So, we allocate about 35 per cent of our diversified options are mostly across infrastructure, real estate and private equity, but increasingly to private debt and private credit.”
Embrace the vol
The idea of being a long-term investor and embracing short-term volatility shocks also figures in how HESTA thinks, according to head of portfolio construction Michael Sommers.
“We’re very much fundamentally driven,” Sommers said.
“If our view of the world suggests this is a good time to take risks, we do it. If we think that maybe now’s not the right time we might dial back, mindful [that] you can’t go too defensive in your positions, as your members are expecting exposure to growth assets that align to their choice of option.
“We have a number of diversifiers in the portfolio…mainly on the unlisted side: property, private equity, infrastructure and private debt.
“DAA is used. While it’s valuation-driven, there will be times we might take a broader total portfolio view. There might be some elements of the portfolio’s needs that maybe a valuation signal doesn’t suggest, but other levers can be used. We do that across a number of asset classes as well.
“But the key one is because we can be medium-long-term investors, we can take on that short-term volatility. [We do] a whole bunch of scenario analysis, a lot of planning to make sure that we have the ability to take advantage of the markets as well.
“So we’re doing quite a bit on the planning side to make sure we can do what we need. It’s quite holistic across the whole portfolio. But ultimately, we don’t want to shy away from volatility.”
Think about the total portfolio
Sommers said HESTA does “quite a bit of thinking about the total portfolio, because when we talk about risk we consider both left-tail and right-tail risks, which helps us to deliver on our CPI+ objectives.”
“Avoiding a stagflation environment has helped to deliver strong returns even with high CPI,” he said.
Mine Super chief investment officer Seamus Collins says volatility is inevitable and balancing the need to generate good long-term returns without causing undue discomfort or alarm for investors can be tricky.
“You’ve got to look through,” Collins says.
“That’s ultimately what we decided. That’s why we’ve also got a life cycle [option] that’s pretty punchy, we hold high growth to the age of 50, and the logic is it’s temporal diversification you’re talking about. You’ve got to look through it.”
Collins said that some time ago the fund incorporated into its purpose statement that it should “provide peace of mind on the retirement journey, which is a kind of nice motherhood statement, as it aims to deliver exceptional retirement outcomes but then was interpreted as a need to manage intra-journey volatility”, which made it difficult to balance the competing demands of adequate returns and members’ peace of mind.
“We used to run a lot of low-vol, a lot of inter-sector risk mitigation and diversification, a lot of alt risk premia and portfolio insurance to essentially fund buying the dip,” he said.
“Doing those sorts of things in the period since the GFC has been unrewarding. In the last quarter of 2018, we did trigger quite a bit of trading around that portfolio insurance and did put it back, but other than that, we really struggled.
“In around 2020 the trustee walked back, essentially, that volatility management and said, ‘We’re long-term investors, we probably don’t want to be trying to manage that shorter-term volatility’.”
A cost to the fund
Collins said there was a cost to the fund “both in peer terms, and also in regulatory terms, once APRA defined what the industry should invest in”.
“But technically, I really liked the strategy,” he said.
“That’s one of the reasons I joined the fund. It was a really advanced strategy for managing sequencing risk and for diversifying through volatile periods, but it was reasonably expensive, and against funds that were just more straightforward, it underperformed for a number of years.
“It also put the onus on us to sort of time the trading around some of those options positions, which we didn’t always get right. And I think the trustee was a little nervous about that kind of trading activity.”
CFS’s Armitage said that while asset owners are indeed long-term investors – or at least they should be – and, in an ideal world, could ride out volatility shocks, that’s not always how fund members think, particularly at times of stress.
“We’ve all seen our members being pro-cyclical in the way that they move money around. That’s a challenge,” he said.
“Whilst you hope to goodness you don’t see a repeat of what happened in 2020, early release also presented challenges, where I think up until then everyone had to sort of reshape their views about the longevity side of things. We are long term investors. However, early release gave everyone pause that you can see in extremis, some changes to that sort of thinking, and then you had member activity around that as well.”
Armitage said member education therefore plays a part in funds’ ability to ride out volatility shocks in a way that ultimately best serves the interests of members by not compromising long-term investment objectives and strategies.
“So, there’s a part to this, which is, a) how do we manage our members and our clients’ money; but also, how do we communicate this?” he said.
“That’s another thing we try and do quite a bit of thinking about. This is a long-term investment and so on, riding things out, but we also know that human behaviour means that the longer these periods go on, the greater the propensity is for certain parts of the membership base to bail out.”
