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Category Archives: Global Tactical Asset Alloction

Feeling Unsettled – An Update on Investor Risk Aversion

New England Spring DayInvestors have been feeling a bit unsettled this year. Right off the bat risky assets fell off the cliff only to recover strongly in March. Since then financial markets have felt like a typical spring day in New England –at times warm and sunny followed by cold winds and clouds.

Investors have become highly sensitized to changing capital market conditions – one moment feeling upbeat and confident and the next being rife with doubt and stress.

Back in 2009 Mohamed El-Erian then at Pimco described the changing mood swings of investors using the risk on/risk off label.

While the risk on/off concept makes a lot of sense to truly grasp the investment implications of such mood swings one needs an objective yardstick to properly identify these periods of euphoria and sheer despair.

At Global Focus Capital we measure investor sentiment using our Risk Aversion Index (RAI).  The higher the RAI the more fearful investor are, or in other words the more risk averse.  As a reminder to readers we classify investor risk aversion into three zones – Extreme Risk/Risk Allergic, Neutral, and Risk Loving/Seeking.

RAI MAY 2016Thus far in 2016 we have spent most of our time in the Extreme Fear/Allergic and the higher end of the Normal Zones.  Investors are clearly nervous.

The chart shows the ten day moving average of our daily risk aversion index.  During the early part of the year risk aversion was in the very high end as global stock and commodity markets were tumbling.

As risky assets found their footing in mid to late February so did investor risk aversion.  After almost reverting back to the Extreme Fear/Allergic Zone in mid-April, investor risk aversion has been trending down while still remaining in the high end of the Neutral Zone. Investor sentiment remains fragile.

What does it mean to be in each one of these risk zones?  Without going into all the portfolio construction issues let us just focus on returns.  A separate note will explore the risk management aspects of each risk regime.

We illustrate average monthly returns since 1995 for the major asset classes typically part of our asset allocation strategies at Global Focus Capital. Among equities and fixed income we split the asset classes into domestic and international and also include alternatives such as real estate and commodities.

RETURNS ACCORDING TO RAI.png

Periods of capital market stress such as those when the RAI is in the Extreme Risk/Allergic Zone (red bars) are difficult for investors holding risky asset classes such as equities.  In line with conventional wisdom the higher the perceived risk the more negative the average returns. When the RAI is in this zone all equities suffer but emerging markets takes the biggest hit (down 2.3% on average). Our two alternatives (Real Estate and Commodities) also take a hit but the overall negative effect is dampened due to their exposure to non-equity risk factors.

Fixed income on the other hand tends to exhibit positive average returns during this high risk aversion phase. In fact, the highest average returns of all asset classes correspond to government bonds (US and Non-US developed market).  US Government bonds for example show an average monthly return of 1% in the Risk Allergic Zone.

Let’s see what happens when the RAI falls in the Risk Loving/Seeking Zone (green bars). Here the situation is reversed. Asset classes with higher perceived risk tend to do better. Emerging market equities do best on average and small caps outperform large cap stocks. Real estate also does well. Within fixed income emerging market bonds do best, but in general the performance of safer assets lags significantly behind that of riskier investments. 

When in the Risk Loving/Seeking Zone it pays to be aggressive, but one must also be mindful of taking on too much risk in exchange for less and less potential reward.  Both the Long Term Capital Management implosion in 1998 and the 2008 Financial Crisis debacles occurred on the heels of investors being highly dismissive of the risks involved.  In both cases investors were taking on a disproportionate amount of risk for smaller amounts of potential return.

Finally when evaluating returns in the Neutral Zone (orange bars) it is interesting to note that, on average, equities tend to exhibit the best monthly returns when in this risk phase. All four equity classes show this tendency. Likewise real estate also shows the highest average returns in the Neutral Zone. Interestingly, the highest perceived risk asset within fixed income – Emerging Market Debt – also shows this characteristic.

Where is the RAI now and what should we be doing? Our barometer is currently entrenched in the Neutral Zone with a reading in the 59th percentile.  The RAI has been trending down (becoming a bit less risk averse) but remains in the higher end of the Normal Zone.  Pick your poison – low global growth, negative policy rates, disappointing corporate earnings, Brexit, a Greek default – investors are finding lots of reasons for remaining nervous.

ACTION PLAN ACCORDING TO RAI

In looking at the pattern of how investor risk aversion typically evolves our research has found that investor risk aversion tends to be sticky over the short-term

There is about a 65% probability of remaining next month in the current risk zone, a 25% chance of moving to the contiguous zone (say from Neutral to Extreme Risk) and only a 10% chance of moving from one extreme to the other (say Risk Seeking to Risk Allergic).

Our current reading of 59th percentile is on the high side for the Neutral Zone.  Coming off the Extreme Risk/Allergic Zone at the beginning of the year the portfolio implication is a lowering of tracking error and an increase in investment volatility.  We are thus advocating becoming less dissimilar from the benchmark if a relative return orientation is applicable.

When investor risk aversion is in the Normal Zone, low volatility strategies lose their effectiveness and we, therefore, do not recommend a low volatility tilt anymore.

Should investors get spooled again and our RAI return to the Extreme Fear Zone our recommendation would be to tilt toward lower volatility investments and sectors.  Such a set of moves would increase deviations relative to the benchmark and we would expect to observe higher levels of strategy tracking error.

What could sour the mood of global investors leading to a jump up in risk aversion? Potentially a whole host of issues frequently best understood in hindsight.  But on a more practical note we would highlight three areas of concern. First, should the UK vote to withdraw from the European Union we would expect a large spike up in investor risk aversion.  Risky assets such as stocks and commodities would likely take a big hit should this event occur.  We think that investors will react extremely negatively to Brexit especially in terms of their European stock and bond holdings.

The second concern involves contagion effects should a Greek default occur.  At the very least the interest spread between safe and riskier debt should jump up.  This would lead to a higher RAI and riskier investments will likely bear the brunt. Haven’t we seen this movie before? Yes, too many times but unless debt relief is in the cards we will we seeing another re-run this summer.

Finally, a Chinese growth scare could also trigger investor fears and bring about very negative consequences for emerging market equities and commodities.  The official target growth rate is between 6.5 and 7% with a focus on internal consumption and services growth.

The wildcards remains the health of the real estate market and the credit worthiness of off-balance sheet financing.  According to the IMF China currently accounts for over 16% of Global GDP when adjusted for purchasing power parity. The US accounts for a similar fraction of global growth. A significant negative revision to growth in either country would no doubt roil equity and commodity markets while leading monetary authorities to expand their loose monetary policy further into the future.

At Global Focus Capital we continue to believe that investment risk has been underpriced for a while and that there is no better time than now to evaluate one’s willingness to trade off risk in relation to potential reward.

Monetary authorities have provided investors with a nice safety cushion and allowed aggressive investors to benefit disproportionally.  Lackluster global growth and seemingly high absolute valuation levels for stocks and bonds are likely to lead to a decade of lower than average capital market returns where many investors will struggle to meet their stated target portfolio returns.

A proper understanding of realistic sources of potential returns and associated risks together with a willingness to remain tactically flexible with a portion of the overall portfolio will reward investors with a higher likelihood of achieving their goals without going too far out on the risk curve.

 

Eric J. Weigel

Managing Partner, Global Focus Capital LLC

Feel free to contact us at Global Focus Capital LLC (mailto:eweigel@gf-cap.com or visit our website at https://gf-cap.com to find out more about our asset management strategies, consulting/OCIO solutions, and research subscriptions.

DISCLAIMER: NOTHING HEREIN SHALL BE CONSTRUED AS INVESTMENT ADVICE, A RECOMMENDATION OR SOLICITATION TO BUY OR SELL ANY SECURITY. PAST PERFORMANCE DOES NOT PREDICT OR GUARANTEE FUTURE SIMILAR RESULTS. SEEK THE ADVICE OF AN INVESTMENT MANAGER, LAWYER AND ACCOUNTANT BEFORE YOU INVEST. DON’T RELY ON ANYTHING HEREIN. DO YOUR OWN HOMEWORK. THIS IS FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSIDER THE INVESTMENT NEEDS OR SUITABILITY OF ANY INDIVIDUAL. THERE IS NO PROMISE TO CORRECT ANY ERRORS OR OMISSIONS OR NOTIFY THE READER OF ANY SUCH ERRORS.

Mind the Gap! Emerging Markets Are Out-Running Developed Market Stocks

mind-the-gap-1484157-640x480Many years ago when my family and I took a trip to London my children took great delight in hearing the loud warning of “mind the gap” when taking the Tube.

To this day we still joke about it and hearing the expression always brings back a flash of fond memories.

But what I had in mind for this note was a different type of gap. Specifically, the gap that is developing between developed equity markets and emerging market stocks.

Going into 2016 sentiment was pretty bearish on emerging market equities.  Institutional investors were having a hard time hanging on to allocations that significantly under-performed expectations and retail investors had long been fleeing the asset class.

Moreover, over the prior ten years (2015-2006) emerging markets had only out-performed international developed markets by an annualized 0.45%.  Clearly not enough once transaction costs and the usually higher management fees are taken into account. Never mind the higher volatility of the asset class.

So what had happened to the emerging markets story? Investors once justifying their EM allocations on the growth of the middle class in these markets (the shift from export-driven to domestic consumption growth) had reverted back to explaining the disappointing performance of EM equities as a function of the collapse in global commodity prices.

At the end of 2015 it was hard to find investors willingly delinking expectations for EM equities from those of global commodity markets. Both asset classes ranked at or near the bottom of the pile in terms of 2016 prospects.

Not that every investors was bearish but you had to be a true contrarian to in the face of public ridicule increase allocations to EM or commodities.  The short EM/Commodity trade had become very crowded indeed!

What usually happens when you have a crowded trade? The short answer is nothing good for the crowd except for the small number of contrarians still hanging on.  Let’s think back to two recent examples of crowded trades:

The rise and subsequent bursting of the TMT bubble of the late 90’s.  Every portfolio manager back in those days felt the pressure to increase their exposure to companies in these sectors despite a lack of sound fundamentals and exorbitant valuations.

  • The real estate finance smorgasbord of builders, mortgage issuers, insurers and credit re-packagers of the 2004-2007 period.  The finance sector as a whole was gorging on low interest rates in the context of a low volatility capital market environment.  The end result was not unpredictable but in its day there was comfort in numbers and the possibility of something seriously going wrong was summarily dismissed by the vast horde of investors then making money on the trade.
  • The funny thing about crowded trades is that before they burst few people are willing to take a count of the players at the party.  Sometimes people will fail to even acknowledge that a party is taking place.  Tunnel vision sets in and investors are subsequently surprised when a turn of events has party attendees suddenly sprinting for the exits.

Is the short EM equities trade finally nearing exhaustion?  It sure feels like it. Systematic ways of looking at the “numbers” will invariably lag price behavior.  Our own allocation models have been pointing to a closing of the gap between expectations for developed and emerging market forward returns but we still slightly prefer the former.

Let’s take a look at major asset class performance in 2016.

AA_WEEKLY_HMAP

  • Last week EM equities were up 3.3% – best of the major asset class categories.
  • For the year, EM equities are up 4.4% -best among all equity sub-asset classes.
  • The gap between emerging and developed international market (EAFE) performance is widening.  Year to date the gap stands at over 7%.
  • The MSCI EAFE index is down 2.68% for the year while the MSCI ACWI-x US index (which has an EM weight close to 20%) is down approximately 0.4%.

The performance gap between developed international and emerging market equities is already causing some anxiety among international equity managers. Managers tied to the broader ACWI index are clearly having to swim upstream given their likely beginning of year under-weight to EM stocks.

Last year the consensus underweight to EM equities paid off handsomely.  EAFE out-performed EM equities by a whopping 14%.  An under-weight to EM equities could have hidden a lot of sins elsewhere in the portfolio but this year the tide has turned.

Having been a money manager for over 20 years I know the feeling when a previously ignored/disliked segment of the markets suddenly changes course and gaps up.

It’s never a good feeling and leaves portfolio managers in search of answers.  In the course of my career I have seen three types of generic responses by managers:

  • Ignoring the problem and remaining steadfast in the belief that the portfolio is correctly positioned.  The likely outcome of the “no action” manager is binary – at the end of the year the manager will either be a hero or a goat.
  • Gradually changing course acknowledging that the trade might have been crowded.  The manager works at finding investments with the right exposures thus gradually minimizing the under-weight to the previously ignored/disliked segment.  In all likelihood the manager will initially make small adjustments and is praying that the performance gap does not widen too rapidly
  • Throwing in the towel and joining the new party by aggressively over-weighting the previously maligned investment.  The potential to be a hero or a goat is large.  Such a response is usually driven by “gut” feelings that things have changed

Only in hindsight will investors be able to tell which course of action resulted in the best outcome.  Portfolio managers live in the present and must make decisions.  With that in mind here is set of principles to adhere to:

  • All predictions contain a certain amount of error – be humble about your ability to predict the future. Low probability events happen more frequently than we would like to
  • Seek to understand opposing points of view as a way to discover flows in your thinking.  You will gain a greater appreciation of what can go wrong
  • Strike a balance between what is happening now (recent evidence) and longer-term information. Don’t let your decisions succumb to feelings of either fear or greed
  • Research-based views are better than reactive off-the cuff conclusions – at least you will understand why you made certain decisions. Do your homework
  • Gradually changing one’s views given changing/new information is not a sign of weakness.  Making better decisions involves the constant calibration of new probabilities
  • There is no substitute for experience in providing context to the decision at hand, but experience without analysis is no way to make decisions in an ever evolving capital market environment
  • Understand the consequence of your decisions – never bet the farm on one major decision unless you (and your clients) are comfortable with binary outcomes

Sincerely,

Eric J. Weigel
Managing Partner of Global Focus Capital LLC

eweigel@gf-cap.com

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Can This Russian Bear Learn To Samba?

I have my own moves!

Last week we wrote about the amazing year to date performance of the Brazilian equity market. Despite all the awful headlines and negative investor sentiment the Brazilian market was up over 20% and last week it went up a further 4%.

A similarly widely disliked equity market fraught with negative headlines having a great start to the year is Russia.

Russian equities were up 2.5% last week and in 2016 they are up about 11%. Not bad for a market that like Brazil comes with lots and lots of baggage.

All resource-oriented equity markets have benefited from the resurgence of commodities and both economies are expected to contract further in 2016, but Russia and Brazil are not cut from the same cloth.

There are at least three key differences that investors should note before lumping these emerging markets together:

  • Economic Sector Composition
  • Fundamental Drivers of Return
  • Value Add of Top-Down versus Bottom-Up Implementation Approaches

Click to read the full report  Can This Russian Bear Learn To Samba?

Sincerely,

Eric J. Weigel
Managing Partner of Global Focus Capital LLC

eweigel@gf-cap.com

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