Volatility, what volatility? Having got used to choppier markets for much of 2018, the past few sessions have seemed like 2017 all over again as the FTSE 100 (UKX) Index climbs back to near record levels.
But this serene performance shouldn’t lull investors into a false of sense of security, even if the VIX index of implied volatility has fallen below its four-month moving average this week for the first time since January.
UBS reminds us in its weekly House View that higher inflation, rising US interest rates and the end of quantitative easing are ever-present threats that mean a return to volatility is unlikely to be too far away.
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Already this year, we’ve seen a peak-to-trough fall in global stocks of 9% compared with a figure for 2017 of less than 3%. However, UBS says this volatile trend is no reason to sell, particularly as earnings growth is still strong and equity market valuations are appealing relative to cash and fixed income.
Instead, the broker recommends a five-step approach where investors are invested and also better equipped to manage the risks.
UBS’s global chief investment officer Mark Haefele said: “Those in properly diversified portfolios are well prepared for the return of volatility.
“But many others are relying too heavily on passive approaches in traditional markets; not managing equity downside risks appropriately; holding concentrated positions; focusing too heavily on generating yield while neglecting risks; and lacking a suitably long-term approach.”
Vanguard FTSE ALL World Ucits ETF (VWRL)
Source: interactive investor Past performance is not a guide to future performance
With this in mind, Haefele recommends adding alternative sources of return beyond classic equity and bond indexes, such as hedge funds – which often outperform later in the economic cycle.
Secondly, investors need to think about lowering their vulnerability to equity drawdowns. Strategies that can offer some protection against tail risks, as well as provide exposure to market upside or a consistent yield, might include equity put options or systematic hedging.
Diversifying globally can also help reduce exposure to specific risks. If owning foreign equities is a problem, then investors should seek out homegrown companies with high international exposure.
UBS also recommends shifting sources of income away from risky credit and excess foreign-exchange exposure, which can quickly turn sour in a more volatile environment.
Finally, the note suggests looking beyond the economic cycle with asset allocations to private markets, sustainable investments, or long-term themes, such as robotics or energy efficiency. This can help boost returns or reduce the temptation to sell at the wrong time and retreat to cash.
Haefele added: “In short, we think being invested in equities is quite likely to work in the short run, and very likely to in the long run.
“Timing an exit from stocks before the onset of a recession can be tricky. While the average rise in the final year of the bull market is 22%, the average recession is accompanied by an equity drawdown of around 20%, based on data since 1928.”
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