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Controlling volatility in equities

October 2018

Marketing Material

Global equity markets are facing a number of headwinds. Economic growth is plateauing, interest rates are rising and valuations look stretched. As a result, after nearly a decade of unusually benign conditions, there are signs that markets are returning back to more “normal” behaviour. That could mean higher volatility and lower returns from mainstream stock markets in future.

That’s an environment for which the long/short (L/S) equity investment approach was designed. Such strategies aim to capture equity upside when markets are rising but preserve capital when the investment climate turns sour. They can do this because they can take both long and short positions in securities. In other words, they can invest in companies with the strongest growth prospects and also establish short positions in firms deemed to be suffering a decline in profitability.

The ability of an L/S strategy to mitigate volatility and limit the scale of losses is particularly important. The power of compounded returns means that, for example, a 25 per cent decline in the value of investments requires a subsequent 33 per cent rally to fully recover ground.

In recent years, the ability to do this was arguably less necessary given both the unusually high returns equities generated and the relative calm of the market.

Artificially low interest rates along with quantitative easing on a massive scale kept a lid on stock market volatility, creating the conditions for individual stocks to move up more or less in lockstep with one another.

But we saw the value of the L/S approach emerge at the start of 2018. In February this year, the S&P 500 suffered a peak to trough drop of more than 10 per cent, while the HFRX Equity Hedge Index – which aggregates the performance of long/short strategies – lost only 3.7 per cent.

And while the S&P500 has recovered and grown from strength to strength, other global markets have been less fortunate. Emerging markets took the bulk of downside amidst wobbles in Turkey and Argentina and trade tensions between the US and China, which coupled with domestic concerns around growth and currency depreciation, put pressure on local equity markets, as illustrated by the MSCI Golden Dragon, comprising China, Hong Kong, and Taiwan equities (chart 1).

year to year return — Source: Pictet Asset Management, Datastream, as of August 2018

Historically, in such times of turbulence, investors have dialled down their equity exposure and turned to bonds. But today that strategy is less likely to work: bonds appear to have lost some of their diversification benefits, tending to both rise and correct in unison with equities in recent years.

1 year correlation — Source: Pictet Asset Management, Datastream, as of August 2018

In contrast, bottom-up stock investing in Greater China – particularly for long/short managers, who have the ability to generate returns from both strong and the weak performers – has the potential to be rewarded given the lower correlation between individual stocks to the overall market in contrast to developed markets such as the S&P (chart 2).

We believe that as global central banks withdraw monetary stimulus, this period of higher dispersion is set to continue. Long/short managers will thus be able to make full use of their bottom-up analysis and stock picking skills, potentially generating excess returns from both winners and losers.

Our research also shows that during the two major bear markets of the past 20 years – January 1999 to September 2002 and October 2007 to February 2009 – long/short equity funds offered investors a far greater degree of capital protection. What’s more, unlike some other diversifying asset classes – such as real estate or private equity – long/short equity portfolios typically invest in liquid instruments.

Overall, then, we believe that current market conditions require a more agile approach to equity investing. Including long/short equities as part of a broader portfolio allocation to stock markets can offer a degree of downside protection – insurance that’s likely to become even more important as markets become bumpier.

The information and data presented in this material are for information purposes only and are not to be considered as an offer or solicitation to buy, sell or subscribe to any securities or financial instruments in any jurisdiction. Investment involves risk. Past performance is not indicative of future results. Before making investment decision, investors should refer the offering documents. The value and income of any of the securities or financial instruments mentioned in this document may fall as well as rise and, as a consequence, investors may receive back less than originally invested. Information, opinions and/or estimates expressed in this material reflect a judgment at its original date of publication and are subject to change without notice. They are not prepared for any particular investment objectives, financial situation or requirements of any specific investor and do not constitute a representation that any investment strategy is suitable or appropriate for an investor’s individual circumstances or otherwise constitute a personal recommendation. If in doubt, please seek independent advice.

This material has not been reviewed by the Securities and Futures Commission or any other regulatory authority. The issuer of this material is Pictet Asset Management (Hong Kong) Limited.

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The information and data presented in this document are not to be considered as an offer or solicitation to buy, sell or subscribe to any securities or financial instruments or services.

Information, opinions and estimates contained in this document reflect a judgment at the original date of publication and are subject to change without notice. The management company has not taken any steps to ensure that the securities referred to in this document are suitable for any particular investor and this document is not to be relied upon in substitution for the exercise of independent judgment. Tax treatment depends on the individual circumstances of each investor and may be subject to change in the future. Before making any investment decision, investors are recommended to ascertain if this investment is suitable for them in light of their financial knowledge and experience, investment goals and financial situation, or to obtain specific advice from an industry professional.

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