Tuesday, May 12th, 2015

Hunker Down

As every fund manager knows, there are two ways of reducing the risk in an equity portfolio. The first is to increase exposure to defensive or low-beta sectors. The second is to reduce total deviation from the benchmark portfolio – a.k.a. the active weight. One tactic aims to protect the investor against a decline in the value of the portfolio; the other protects the fund manager against the risk of underperformance. Both tactics have their uses at different stages of the cycle, and both are equally revealing about what investors are afraid of.

In recent weeks all our regional equity models have shown a significant reduction in their recommended active weight. In most cases this has gone from a two-year high to slightly below average. At the same time we see no major shifts in the pattern of over and underweight positions. So investors have not changed their sector preferences, just the level of conviction with which they are prepared to back them. They are more concerned by the prospect of underperforming the index, than losing money in equities.

The question is why? It’s partly down to seasonality. The end of May is traditionally the time when all our regional equity models recommend their lowest active weight. It’s our version of “Sell in May” *, so it is not surprising for the active weight to be low now. However, for the previous four months of this year, active weight was above the seasonal average and in the last four weeks it has been falling much faster than normal. This process is most advanced in the US, which tends to lead the other regions when it comes to issues of risk management. This suggests a sudden reappraisal of the nature of the risks confronting equities as an asset class.

We think that this was caused by the behaviour of bond yields over the last month. The biggest reductions in active weight over the last four weeks have come in the US and the Eurozone, which are the regions where we have seen the biggest sell-off in bonds. Third on both measures is Japan, with the UK in fourth place (although direct comparisons may be distorted by the general election). In the short term, rising yields accompanied (as they are now) by rising volatility depress the risk-adjusted returns of bonds and make it more important to be in equities as an asset class, rather than select which ones you are going to be in. Over the medium term a rise in the risk-free rate will eventually put pressure on equity valuations, and put a premium on the timing of the decision to go back into bonds. The liquidity to execute these switches is only available at the index level, not for individual stocks or sectors.

Describing the problem may be a little difficult, but the investment conclusion is surprisingly simple. If you have no strong convictions about which stocks or sectors to own, it’s OK to hug your benchmark for a while. The really important decisions in Q2 relate to the split between equities and bonds. And if you feel nervous about this decision, it’s probably OK to increase the amount of cash in the portfolio as well.

* The seasonal highs are September for the US, October for Japan, November for the UK and February for the Eurozone.

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