Rebalancing in the wake of the U.S. elections: How an overlay can help
In the wake of the U.S. elections, we sat down with Tom Fletcher, managing director of overlay services, to assess the path ahead for markets.
Q: We have seen the VIX come down after the election. Is the worst of the volatility behind us?
A: VIX is reaching levels in the low 20’s, levels we have not seen since before the March 2020 correction. It is still elevated from a historical perspective, but perhaps indicative of realized market volatility awaiting us in the future. Forward VIX levels (as observed in VIX futures contracts) showed an elevated expectation for volatility at the November expiration before the 2020 election, that effect has softened and shifted out to January when Senate runoff elections in Georgia will determine the extent of consolidated partisan power driving the fiscal policy agenda. With much of the election uncertainty behind us, the news flow shifts more toward COVID-19 vaccine availability, treatment improvements and the degree of economic impairment that occurs before the epidemic is under control such that we can settle into a "new normal." No one is prescient regarding the outcomes of these opposing forces, or the implication of them on the markets – this is new territory for all of us. What we can say with near certainty is that between now and the time it takes to reach the "new normal," there will be numerous market overreactions along the way. It is important to remain disciplined and stick to longer term investment plans, turning these eventual overreactions into opportunities.
Q: With an expectation for ongoing volatility, what are the most important things to manage regarding asset allocation?
A: To twist a common theme from real estate investing - rebalancing, rebalancing, rebalancing. Asset allocation policies attempt to define a portfolio that can survive all foreseeable outcomes, while meeting challenging return targets over the long term. An overlay provides a very efficient mechanism to rebalance. It is critical to remember that a policy portfolio is the sum of monthly asset class returns, held at policy weights at the onset of each month. The policy portfolio return is a very challenging benchmark to beat since it gets the benefit of free monthly rebalancing over time. We all know that rebalancing is not free, so it is important to keep rebalancing transaction costs down, while ultimately not creating undue risk to policy as holdings deviate from policy targets. An overlay is the most cost-effective way to manage tracking error to policy from asset allocation drift, but it also limits distraction from alpha generation activities of manager/security selection. From our perspective, material deviations from policy are better done as intended risks (with an expectation of value-add to policy) rather than unintentional exposures generated by market movements.
Q: If generally constructive on risky assets, how do you stay invested with conviction?
A: Effective diversification is critical to position portfolios such that a correction does not knock them off course. Over a long enough horizon, drawdowns along that path are a certainty -- such is investing in risky assets. A liquidity crunch is the most common cause for losing investment conviction– liquidity provisioning is a key area for preventive maintenance when times are relatively calm. Since most of our clients are in the business of making payments from the investment portfolio, it is beneficial to have something that is up in value (when the bulk of risky assets are down) to meet liquidity needs. Multiple levels of liquidity provision are something to establish while conditions are calm. Tier 1 is the Operating Cash account – an overlay allows for a reserve of settled cash to be held to meet ongoing needs, without the need to settle for near zero cash returns on that allocation. Tier 2 is allocations to Treasuries and lower risk fixed income exposures that have low risk of freezing up under market stress – dedicated allocations here work better than counting on return seeking Fixed Income managers' less-liquid portfolios. Tier 3 is selling passive equity exposure – even if a market sell-off leaves you underweight to policy in equities, broad passive equities can still be liquidated with less transaction cost impact than a concentrated active portfolio. In this case, cash raised from selling equities can be replaced by equity futures, thereby improving the level of cash to meet emergency needs. With increasing allocations to illiquid and private assets, which often demand more liquidity in times of market stress than they generate, liquidity planning is more important than it has ever been in the public portion of the portfolio.
Q: What other risks are rising besides concern over an equity market correction?
A: Effective diversification is more challenging than it used to be. For the past 40 years, we have been in a disinflationary environment, a regime in which there was a general downward trend in rates. On the positive side, this meant that holding Treasuries brought the promise of the coupon as well as potential capital appreciation as yields declined. Today, Treasuries start at a very low coupon rate, and there is risk of an eventual shift to reflation detracting from that already low return expectation. Even if Treasury yields don't rise materially from here, Treasury exposure probably only has half of its historical diversification benefit during the event of major risk-off event in markets. We need to look beyond Treasuries for diversification increasingly, but there is an ever-shrinking set of assets to choose from that offset equity market risk. Allocations to gold and other stores of value (such as resource stocks) may have a role to play in offsetting risk of rising inflation expectations, but that is a topic for another discussion.