Market discounting low volatility at its peril, warn CIOs
Most investors are not properly positioned for a low-volatility environment and will need to revamp their portfolios considerably if market fears remain unrealised, say global CIOs at Manulife Asset Management.
“If rates don’t change there are so many investors, both retail and institutional, who will take a significant hit,” says Christopher Conkey, the firm’s chief investment officer for global equities.
“That’s because a whole portion of their portfolio that they seek stability from will provide virtually no return. It goes to the point about risk-free treasuries becoming return-free risk. It’s a phenomenal mismatch in terms of global demographics for corporations and pension plans.”
Conkey notes that the VIX, a measure of equity volatility commonly known as the fear index, has fallen sharply (to 17.1 at the start of this month, its lowest level since July, finds Bloomberg).
Last year the big “unknown unknown”, as Conkey terms it, was the depth of the eurozone debt crisis, and he concedes that volatility will likely persist as the deleveraging process continues.
However, he also points to the semi-coordinated central bank response designed to stimulate growth, as well as the underlying strength of corporate balance sheets as evidence that volatility may not roil markets as many investors expect.
“The VIX will be driven by headline macro risks, but is the Greek or eurozone debt situation going to be the next Lehman Brothers? I don’t think so, mainly because the banking system is so well capitalised on a global basis,” says Conkey.
“While Europe has its challenges, it is working through them, and in my view the unknown unknowns have decreased dramatically. Now it is a question of the known unknowns and how much that has been factored into equity prices.”
The prospect that volatility will not be as bad as feared is also something that animates Barry Evans (pictured), Manulife AM’s CIO for global fixed income and asset allocation.
“In a lower volatility market you enter the world of carry [trades]. But most investors aren’t looking at carry or at equities, they are looking at risk-on, risk-off. I would say most people are not properly positioned for a low volatility market,” he says, noting that minimising Treasuries and owning high-yield debt might be more appropriate.
On the equities side Manulife AM manages $58 billion globally, of which about $20 billion of this is passive via index replication, although its holding of ETFs is small.
Geographically US equities account for 26% of AUM and Asia-Pacific about 17% ($10 billion). The firm’s biggest source of Asian equity is Hong Kong’s Mandatory Provident Fund platform.
Conkey confirms that Manulife AM has raised its equities exposure from 60% in a typical balanced portfolio to around 70%. It operates a bottom-up stock-picking style, and has maintained an overweight in emerging markets, energy-related stocks and technology.
In Asia-Pacific the two markets its portfolio managers are overweighting are South Korea and India. But Conkey is cautious on A-shares on the grounds that China is enduring a negative real-rate situation where it’s hard to see real assets doing well.
Another theme Manulife is positive on is consumer discretionary, noting that savings rates have stabilised in the US. Conkey mentions Amazon as one stock it views favourably.
On the fixed income side Manulife has $79 billion in assets, of which $28 billion is Asia-based. It also has asset allocation assets totalling $89 billion, of which Asia accounts for $3-$4 billion, with a heavy focus on target date and target risk funds.
Manulife leverages 30% of asset allocation through internal strategies (of which a third is passive), while the remaining 70% is via third-party managers.
Evans notes that Manulife is putting in place a higher beta asset allocation structure and is bearing more risk in alternatives.
On the fixed income side it is also overweight corporate credit, with for example 80% exposure to spread products and 20% Treasuries in a generic aggressive bond strategy.
Manulife recalibrated its bond portfolio to better reflect a world in which yields are down 50-60% and price risk up 40%. This means it spread the three legs of risk out to take on more interest rate risk, more credit risk and, to a certain extent, more currency risk.
“We will bear more currency risk when we think we will get some appreciation in the currency, but if not we will hedge it back to the home currency or whatever the neutral position of the portfolio is,” says Evans, noting that adding currency risk does not mean you get paid more.
Within portfolios he suggests that around 18% of exposure is below investment grade, with 6-7% in emerging markets and a lot more premium credit exposures. ‘We have probably increased our high-quality bank exposure just a bit because it seems to be banks are leading the way out.
“I don’t like the story or the politics related to it, but I like the credit premiums and I am willing to bear a little more exposure to high quality banks around the globe.”