Markets are displaying many of the hallmarks of the late part of the cycle, a period characterised by positive risk asset returns but higher than usual volatility.
As a case in point, many equity markets are currently at or near all-time-highs. However, the violent swings in August serve as a warning against complacency.
How, then, to invest in such an environment?
Market volatility is an inevitable aspect of investing. The August crash, though brief, highlighted several critical truths. Experience tells us that, while the music is playing, refusing to dance can be a costly mistake. However, when markets become too concentrated behind a narrow set of assumptions, contradictory evidence can cause overcrowded trades to unwind rapidly.
The key pillar of our approach given current conditions is to retain exposure to further upside while avoiding the overcrowded areas of the market most vulnerable to quick shifts in sentiment.
To this end, we still have a broadly risk-on stance in our portfolio, but we have taken steps to add positions that will offer protection in a range of adverse scenarios. These are typically in the areas of the market better value and overlooked by the masses.
This is why, over the summer, as the market became increasingly concentrated in a small number of trades, we began to move into less inflated areas such as small caps, Reits, Italian stocks and energy companies, while maintaining a reasonable allocation to the more fundamentally attractive and less crowded areas within technology, thereby retaining our ability to participate in further upside.
We are also on the lookout for areas with idiosyncratic return drivers that are less correlated with the broader market. One example is biotech, which we believe has similar growth prospects to AI – new treatments and new synthetic materials and food have the potential to create a paradigm shift. However, the sector remains under the radar, especially compared to the hype around AI.
In addition, while markets were complacent and volatility was low, we took the opportunity to cheaply add protection via our options hedging strategy. So when volatility exploded in August, we traded actively to crystallise gains as these hedges increased exponentially in value.
As panic abated, we rebuilt our protective options positions, always making sure we have the right level of protection for prevailing conditions.
The government bond part of our portfolio has performed well recently (we hold only euro duration and virtually no US treasuries). However, with growth slowing and rates coming down, we are reluctant to sell to lock in the gains.
Instead, we initiated a small commodities position to protect these profits, as they should outperform if growth or inflation picks up again. This is an example of how thinking creatively about the exposures we take builds a portfolio resilient to a range of macroeconomic scenarios.
August’s crash might be yesterday’s news to some market participants, but it offers valuable insights. It will go down as one of the ‘mini crises’ that last anything from a week to several months, such as the quant crisis of August 2007. Markets typically recover quickly and move on. However, this type of market event is often a precursor to a much more significant crisis.
While macro conditions still suggest we are heading for a soft landing, the episode serves as a stark reminder that crises can emerge unexpectedly. Overcrowded positions, extreme valuations and various imbalances (excess liquidity, high interest rates, currency misalignments and leverage) are all current risk factors.
Risk management does not mean guessing when an adverse event may occur, but how prepared you are and what you do as a result. Given the unpredictability of market movements, it is crucial to maintain a dynamic approach to portfolio management. For us, this means re-establishing protective hedges while controlling their cost, avoiding overcrowded trades and incorporating assets like gold and antifragile currencies to provide liquidity during risk aversion spikes.
Mario Baronci is multi-asset portfolio manager at Fidelity International
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