Guard­ing against eq­uity mar­ket bears by in­vest­ing in volatil­ity

Financial Mirror (Cyprus) - - FRONT PAGE -

As an as­set class, volatil­ity is grossly un­der­val­ued, par­tic­u­larly when it comes to Asian eq­ui­ties. That Asia is now ground zero for all the fi­nan­cial tur­moil in eq­ui­ties mar­kets has re­fo­cused at­ten­tion on the im­por­tance of volatil­ity. Sev­eral is­sues have been re­spon­si­ble for in­creas­ing global volatil­ity of late, in­clud­ing Puerto Rico’s de­fault, the restruc­tur­ing of the Greek econ­omy and the de­val­u­a­tion of the Chi­nese CNY. This begs the ques­tion: Should we be fo­cus­ing on di­ver­si­fy­ing fi­nan­cial port­fo­lios at this junc­ture?

Asian mar­kets have seen tril­lions of dol­lars of value erased from their bourses in re­cent months. As a case in point, the Hang Seng China En­ter­prises In­dex has plunged al­most 39% from its May high. Once eq­ui­ties mar­kets face this kind of tur­moil, mar­ket par­tic­i­pants scram­ble for cover. Tra­di­tional safe-haven fi­nan­cial as­sets in­clude things like gov­ern­ment bonds and gold. The US dol­lar has also proven to be a pre­ferred safe­haven as­set dur­ing these tu­mul­tuous times. That the dol­lar is strong vis-a-vis a bas­ket of cur­ren­cies is also part and par­cel of a longer term trend that has pre­cip­i­tated weak­ness in emerg­ing mar­ket economies such as Brazil, Rus­sia, In­dia, China and South Africa. Nonethe­less, in­vestors are hold­ing on to their dol­lars and short selling EM cur­ren­cies. History has shown us that weak eq­ui­ties mar­kets and high volatil­ity go handin-hand. This knowl­edge can be used to great ef­fect for in­vestors with broad-based fi­nan­cial port­fo­lios.

We are see­ing changes in the way that safe haven as­sets are be­ing per­ceived. Many of the world’s largest in­vest­ment banks are buy­ing high volatil­ity in­stru­ments such as Chi­nese eq­uity volatil­ity. By pur­chas­ing volatil­ity in­stru­ments, in­vestors are hedg­ing against sharp declines in eq­ui­ties. In or­der to profit off of volatil­ity in the fi­nan­cial mar­kets, one has to be able to iden­tify and iso­late it ac­cord­ingly. Volatil­ity in­stru­ments are dis­tinct as­set cat­e­gories in the fi­nan­cial mar­kets. In other words, tra­di­tional diver­si­fi­ca­tion method­ol­ogy is be­ing chal­lenged by groups of in­vestors plough­ing their money into volatil­ity as­sets. Some­times this takes the form of op­po­site ends of the spec­trum within the same as­set class. You may go short on Asian eq­ui­ties and long on US eq­ui­ties, as an ex­am­ple. Al­ter­na­tively, if you’re trad­ing in cur­rency pairs, you may de­cide to short the CNY and go long on the USD. Trad­ing with the trend is es­pe­cially im­por­tant dur­ing times of high volatil­ity, since trends rep­re­sent long-term pat­terns, es­pe­cially where high vol­ume is in­volved. It is not nec­es­sary to trade within the same as­set class on op­po­site ends of the spec­trum – one can do so across dif­fer­ent as­set classes by go­ing long on US gov­ern­ment bonds and short on US eq­ui­ties, for ex­am­ple.

The goal with re­gards to volatil­ity in­vest­ments is to boost the over­all value of a fi­nan­cial port­fo­lio by tak­ing op­po­site po­si­tions on as­sets. By go­ing long on eq­uity mar­kets volatil­ity at this point, and short on eq­ui­ties, one can pro­tect an in­vest­ment port­fo­lio to greater ef­fect. A caveat is in or­der with re­spect to volatil­ity in­stru­ments: these do not func­tion as a sub­sti­tute for diver­si­fi­ca­tion into other as­sets. As such, volatil­ity in­stru­ments are best per­ceived as ac­cou­trements to your over­all fi­nan­cial port­fo­lio. They are es­pe­cially use­ful to have in times where mar­ket un­cer­tainty re­sults in plung­ing eq­ui­ties mar­kets. The mere pres­ence of volatil­ity in­stru­ments war­rants care­ful con­sid­er­a­tion and eval­u­a­tion by in­vestors. One can never be too cau­tious when it comes to these in­stru­ments, and the ad­vice and coun­sel of mar­ket ex­perts is al­ways a step in the right di­rec­tion. The mar­kets can never es­cape volatil­ity – it is the one con­stant across all as­set classes – cur­ren­cies, com­modi­ties, in­dices and stocks. We need to be fo­cused not on erad­i­cat­ing it, but on man­ag­ing it for our own ben­e­fit.

More and more, in­vestors are feel­ing un­com­fort­able when it comes to long-term eq­ui­ties. The sheer scope of re­cent mar­ket melt­downs has ef­fec­tively erased many of the gains that eq­ui­ties mar­kets have racked up over the years. For ex­am­ple, the Dow Jones In­dus­trial Av­er­age has a year-to-date re­turn of -7.58%, and a 1-year re­turn of -0.79%. The S&P 500 has a ytd re­turn of -5.22% and a 1year re­turn of 1.23%, and the NAS­DAQ has a ytd re­turn of -0.60% and a 1-year re­turn of 6.57%. These fig­ures sug­gest that in 2015 US eq­ui­ties mar­kets – the world’s big­gest econ­omy – are los­ing money. This is in­creas­ing the volatil­ity in the mar­kets which drives eq­ui­ties prices lower. It is clear that many in­vestors are selling when they should be buy­ing eq­ui­ties (bet­ter value). Re­bal­anc­ing of fi­nan­cial port­fo­lios is another im­por­tant task that must be done. In other words you take as­sets from a strong per­form­ing as­set class and move them into a weaker per­form­ing as­set class. Dur­ing times of high volatil­ity the worst thing to do is to panic. Cor­rec­tions are a nor­mal mar­ket phe­nom­e­non and even bear mar­kets turn around. Do not be lulled into a false sense of se­cu­rity by selling when the mar­ket is at its nadir – wait for the up­turn. Suc­cess­ful in­vestors al­ways stay the course. To pros­per dur­ing times of un­cer­tainty diver­si­fied port­fo­lios are an ab­so­lute ne­ces­sity. One does not buy an as­set that is per­form­ing well – the best tech­nique is to strate­gise about which as­sets are likely to do well in the fu­ture and in­vest ac­cord­ingly.

In­vestors with multi-as­set fi­nan­cial port­fo­lios have been put to the test in re­cent months. What be­gan with the Greek debt cri­sis soon bal­looned into a Chi­nese eq­ui­ties melt­down, which be­came a global fi­nan­cial catas­tro­phe in the mak­ing. Eq­ui­ties mar­kets are un­sta­ble around the world, and in­vestors are look­ing to shore up their port­fo­lios by di­ver­si­fy­ing into tra­di­tional safe­haven as­sets such as US Trea­suries, the US dol­lar, and gold. From 2013, eq­ui­ties mar­kets have been char­ac­terised by low lev­els of volatil­ity in the US.

Newspapers in English

Newspapers from Cyprus

© PressReader. All rights reserved.