The August 2015 meltdown wiped more value off emerging market shares than at any other time since the collapse of Lehman Brothers. This has seen investors become increasingly focused than ever on China’s economic fortunes.
The shock Chinese yuan devaluation sent at least half of the main developing countries into bear market territory in August. The market capitalisation of the 31 largest emerging equity markets fell by US$2 trillion, according to data compiled by Bloomberg.
With world equity markets selling off sharply since mid-August, it is noteworthy that the FTSE/JSE All Share Index (ALSI) had already started rolling over in April. This was despite substantial rand weakness that has historically supported shares with offshore earnings. To look at it differently, in US dollar terms, the ALSI was down more than 20% from its highs and volatility remained elevated. Risk is currently a very relevant topic of discussion.
VOLATILITY IS HERE TO STAY
The recent financial market turbulence is a sober reminder that, while equities are the best long-term source of real returns, they are prone to periodic bouts of potentially wealth-destroying volatility.
The risk of further sharp downturns in global equity markets remains high − given high equity valuations, the start of the US rate hiking cycle and intense concerns around Chinese growth prospects. With these and other variables at play in the current downturn, uncertain future prospects raise the likelihood of frequent bouts of market sell-offs and volatility.
WHAT GOES DOWN, MUST GO UP EVEN MORE!
Let’s consider the impact volatility has on an investor’s portfolio:
It’s clear that the greater the initial loss of capital, the greater the required subsequent gain that is needed to make up the loss and get back to the portfolio’s starting value. For example, assume an investment of R100 in a portfolio that subsequently fell 10% to R90. If this portfolio now gains 10% from R90, the portfolio value will be R99. The investor will still have lost R1 of their capital. To recover the full loss from R90, the portfolio needs to gain 11% from R90 to get back to the initial capital invested.
Now consider that at the peak of the global financial crisis in October 2008, the peak-to-trough fall of the FTSE/JSE Shareholder Weighted All Share Index (SWIX) was almost 40%. To recoup that loss, the stock market needed to rise by 67% to achieve breakeven again.
Given the potentially negative impact of volatility on investors’ wealth, an obvious question is whether it is possible to get access to equities and the inflation-beating properties of this asset class at consistently lower volatility?
REDUCING VOLATILITY FOR LONG-TERM EQUITY INVESTORS
A long-only, fully invested equity strategy that seeks to consistently maintain lower portfolio volatility relative to a given benchmark may be described as a managed volatility portfolio or as a minimum volatility portfolio. This is generally achieved through sophisticated portfolio construction processes.
STRESS-TESTING A MANAGED VOLATILITY STRATEGY
To evaluate the outperformance (or alpha) of our Managed Volatility strategy relative to its benchmark (SWIX), we look at three different market environments:
It is important to note that the strategy remains fully invested at all times and does not use derivatives at all.
CAN A LOWER VOLATILITY STRATEGY GENERATE OUTPERFORMANCE?
To answer this question, we have charted the performance of the MSCI SA Total Return Index and the MSCI Minimum Volatility Index for the period November 2001 to August 2015. The MSCI SA Index is a traditional market capitalisation-weighted index whereas the MSCI Minimum Volatility Index demonstrates the performance of the MSCI minimum volatility strategy.
The MSCI Minimum Volatility strategy outperformed the conventional MSCI SA Index over the 14-year period to August 2015. Similarly, the Old Mutual Managed Volatility Fund has outperformed the SWIX (see below).
Indeed, counter to prevailing wisdom, higher risk (volatility) has not necessarily led to higher returns. The key benefit of consistently maintaining lower volatility than a particular benchmark is capital is better preserved in falling − or volatile − markets.
Rising market volatility presents both an opportunity and a risk for long-term investors. It’s an opportunity provided that capital is preserved efficiently and investors can harness the subsequent power of compounding off a higher base. Volatility also poses a risk to investors’ wealth because capital is not preserved efficiently, requiring ever larger capital gains to recoup any capital losses. Investors would do well to consider how they are positioned to benefit from the high level of market volatility in their equity and multi-asset class portfolios.