Asset managers face a paradox: to demonstrate their ability to obtain long-term results, they must show their competence at managing short-term volatility, says Edouard Senechal, senior research analyst on the Dynamic Allocation Strategies team at William Blair.
While this may seem a disconnect, “it is rational to think about the short-term,” says Senechal, since performance is established in the short term: “to generate long-term returns, you need to generate short-term credibility.”
Real return on global equities was 5% for the period 1900 to 2015, according to the Credit Suisse Global Investment Returns Yearbook. However, says Senechal, “risk is rewarded over time but it is not rewarded all the time.”
Starting points matter greatly. But again, there is a paradox: buying securities cheaply means buying them when they are out of favour. Senechal uses Ireland as an example. When the writer Michael Lewis featured it post-crash in a 2011 Vanity Fair article, he compared modern Ireland to Vietnam in the 1950s and to itself during the Great Potato Famine. “But this is where your valuation metrics are telling you where to invest,” he adds.
“What you need is trust with your clients,” Senechal says, and trust is established in managing short-term risk. “If you exceed your risk budgets in the short-term … then your clients may lose confidence.” As a result, it’s imperative “to take a different level of risk in different environments.”
To manage short-term volatility towards a constant target, Senechal suggests three focus areas. One is to heed activity in the options markets. The second is to track macro-themes and their covariance. The third is to analyze
and understand geopolitics.
TO HEDGE OR NOT TO HEDGE?
Together, these are pointers of risk that may need to be hedged away. But, he argues, “if we hedge linearly, we give up the long-term opportunity,” thanks to market timing uncertainties.
The converse is to use options to hedge in non-linear fashion. Here, the cost is paid up front, rather than in foregone opportunities. There are trade-offs, Senechal says.
Because there is a demand for hedging, “you tend to overpay when you buy protection.” In a variance swap, realized volatility is typically less than expected volatility because of this excess demand. This suggests an opportunistic and dynamic strategy.
“When we buy protection, we want to have a clearly established risk that we are trying to hedge. If we blindly and consistently hedge over the long run, we will ultimately realize negative performance.”
As an example, he cites Brexit. The risk was already priced in the market, so it made sense instead to use a linear hedge. However, volatility peaked after the vote — despite the drop in uncertainty. That made for attractive pricing in selling protection through options.
A second way to manage risk concerns currencies. For fundamental investors, Senechal says, assets are often
correlated — either undervalued or overvalued together. That makes it hard to find diversified opportunities. But currencies by nature are less correlated with each other and with traditional asset classes, and therefore offer a constant source of diversifying investment opportunities.