Andrew’s Angle

Market volatility doth make
cowards of us all

Dec 18, 2018

The capacity of factor strategies appears large 

I’ve long advocated using factors to maximize long-run portfolio diversification. In most market environments, diversification can help offer protection against any one dominant source of risk. But, in some extreme conditions, short-term shocks may dominate. In these cases, investors may wish to temporarily shift to more defensive positioning.

Do not swear by the moon, for she changes constantly

Market volatility is back! Some investors who have gotten too used to a multiyear bull market have been surprised by seeing both stocks and bonds recently struggle.

In the long run, diversification works because there are likely some factors, or asset classes, which might pay off when others underperform. We construct long-term asset allocations to maximize diversification benefits over long-term market cycles. But as the bard says, markets can be fickle in the short run and several factors can simultaneously underperform. These are times when investors may want to position their portfolios defensively.

Defensive factor positioning aims to mitigate losses by periodically reducing risk in extreme market conditions. This is different from trying to generate additional returns by dynamically over- and under-weighting factors over time, which we discussed in a previous post. Put simply, defensive factor positioning focuses on managing risk, while opportunistic tilting aims to enhance returns. By managing risks effectively, investors can potentially mitigate portfolio drawdowns during stressed market environments.

To be or not to be? That is the question.

No measure, quantitative or otherwise, can definitively forecast what is to be. But our analysis suggests three key measures to help identify the market extremes that can prove dangerous even for diversified portfolios:  

  1. Risk tolerance indicator – a measure of investor sentiment, designed to identify flight-to-quality environments
  2. Diversification ratio – identifies spiking correlations which can erode the benefits of diversification
  3. Factor valuation ratios – measure current factor prices relative to their long-term historic averages

The first two indicators, used in tandem with factor valuation metrics, provide a quantitative toolkit to monitor periods of extreme market stress.

Now is the winter of our discontent

The first measure of investor sentiment looks at the relationship between risk and return across asset classes. In normal environments, higher risk assets are associated with higher returns. For example, over the long run we expect global equities to deliver a higher return than global bonds. However, we typically see this relationship invert during risk-off environments when investor sentiment sours: investors tend to flock to lower-risk assets and perceived “safe-havens” like government bonds. These dynamics can persist for many months, suggesting that investors could benefit from taking a more defensive stance in a sustained “risk off” environment.

Shall I compare thee to a summer’s day?

During the bright, normal times, diversification is rewarded in our portfolios and bonds can provide a ballast to equities: in normal market environments, on average, bond markets rally when equity markets fall. However, on a cold winter day, things we take for granted can break down and like 2018, global stocks and bonds declined together.

When correlations unexpectedly rise, the assets meant to be diversifying do not provide the protection we expect. The diversification ratio seeks to identify these blustery periods when correlations between asset classes spike, reducing the benefits of diversification. In these rare market environments, even well-diversified portfolios are subject to drawdowns as assets move in lockstep.

Rich gifts wax poor

Factors, like all investments, can periodically be rich or cheap compared to their long-term histories. We construct bottom-up valuation indicators for each of our macroeconomic factors, measuring current prices relative to historic long-term averages. A positive score indicates the factor is cheap, while a negative score indicates the factor is expensive. A factor is fairly valued compared to its own historical long-term average when its valuation score is zero.

Measure for measure

As factor investors, we maintain a multi-asset framework that is well diversified across our six macro drivers of return – economic growth, real rates, inflation, credit, emerging markets, and liquidity. We systematically monitor risk, and in the rare event that our measures indicate extreme levels of market stress, we can take action to defensively reposition the portfolio. The magnitude of portfolio repositioning should be significant enough to materially lower the overall level of risk in the portfolio.

We can describe this defensive factor positioning framework to increase portfolio resiliency with three steps:

 Increase portfolio resiliency with three step

For illustrative purposes only

The course of true love never did run smooth

Shakespeare could have said the same thing about investing. Being diversified across multiple sources of return is our first line of defense against increased market volatility, but we can aim to further boost portfolio resiliency by incorporating quantitative measures to identify potentially dangerous market environments. This additional toolkit can help investors navigate all types of market environments while remaining focused on what matters most: maximizing long-term portfolio returns – true love indeed!

Andrew Ang
Head of Factor Investing Strategies
Andrew Ang, PhD, Managing Director, coordinates BlackRock’s efforts in factor investing. He leads BlackRock’s Factor-Based Strategies Group which manages macro ...