Dennis Doody
Investors have endured an unsettling few months. But there are some things they can do to prevent a case of investors’ flu from turning into pneumonia.
At a Glance
- The widely publicized subprime mortgage crisis and soaring crude oil prices have contributed to considerable market volatility in recent months, inducing queasiness among institutional investors.
- A four-layer approach to asset allocation that carefully considers assets, liquidity, currency, and risk may be the best strategy for maintaining an institution’s financial health through today’s volatile market.
- Perhaps the biggest challenge in such financially turbulent times is keeping fear in check.
Last fall, we began to get predictions about what kind of a flu season lay ahead. What type of strain would we encounter? Is the supply of vaccine sufficient? How bad would it get? We all were worried about the kind of flu that can send you to bed for a few days.
In retrospect, it was financial market flu that turned out to be the far more virulent strain, leaving investors emotionally wrung out, if not physically ill.
For alternating bouts of chills and fever, it was quite a winter. The S&P 500 Index declined for five straight months through March 2008, marking its longest losing streak since 1990. By March 31, 2008, the same index had retreated 16 percent from its high in October 2007. Going abroad hasn’t offered much relief. The MSCI World ex-U.S. Index fell nearly 9.0 percent in the March quarter and the MSCI Emerging Markets Index was off just about 11.0 percent.
All of this meant that domestic stocks teetered on the edge of a bear market, using the definition of a bear market as a decline of 20 percent or more. But that was only part of the story. What really had investors feeling green about the gills was the volatility.
The Outbreak of Volatility
In brief, U.S. market volatility hit a five-year high in recent months. In the first quarter of 2008, a key measure of volatility—the VIX Index—increased an average of 75 percent over its year-earlier level. The Chicago Board of Options Exchange (CBOE) VIX is a commonly used measure of the market’s expectation of volatility and risk over the next 30-day period. A high VIX Index is associated with periods of increased volatility and uncertainty in the market—probably why it is sometimes referred to as the “fear gauge”—while a lower level corresponds to less volatility and stress.
The VIX tracks the widely followed S&P 500 Index, and VIX options and futures are among the most widely traded contracts on the CBOE. The CBOE also has volatility indexes for the NASDAQ 100 (called the VXN) and the Dow Jones Industrial Average (called the VXD). Both are far above their level of the past few years, when volatility was muted.
Investors can adjust to bull or bear market conditions. What really distresses them is the wild swings and the speed at which they take place. The United States had 12 sessions in the first quarter in which share prices rose or fell more than 2 percent in one day—something that did not happen at all in 2004 and 2005. The biggest one-day change came on March 18 when the S&P 500 soared 4.2 percent as the Federal Reserve sharply reduced the Fed funds and discount rates. That was the largest daily move for the index since Oct. 15, 2002, when it soared 4.7 percent as the bear market that began in 2000 bounced off its lows.
Even these gyrations seemed tame compared with the contagion that investors abroad endured. In France in the first quarter, the CAC 40 index fell 6.8 percent in a single day, only to rise more than 6 percent a few days later. Germany’s DAX took a 7.2 percent hit in one day. Hong Kong’s Hang Seng gained 10.7 percent one day in the first quarter and gave up 8.7 percent in another. Each move occurred in a single day! Collectively, the Asian markets had 27 days in the first quarter when indexes moved 2 percent or more. For some, it was just plain bad news. Japan’s Nikkei 225 was down 18 percent in the first quarter.
And China and India were off 27.0 percent and 27.9 percent, respectively, in local currency terms.
Investors should remember that volatility is neither an up-trending market nor a down-trending market, but a combination of the two. In some ways, high volatility indicates a nearly trendless market in which there is a lot of churning but little movement, although the move over the past two quarters has had a distinctly downside bias. Human nature being what it is, investors tend to welcome up-trending markets (a.k.a. bull markets) just as they eschew down-trending markets.
Essentially, volatile conditions reflect the return of a risk premium to the stock market. Risk is ever-present, of course, but investors tend to discount it when economic, business, and political conditions are benign. But when conditions deteriorate, risk gets repriced and it takes a lot more in the way of potential reward to induce people to invest in stocks.
Exacerbating Factors: The Causes of Ills
Our current bout of volatility can be traced to several concerns.
The subprime mortgage situation is well documented; estimates are that it and other losses flowing from financial institutions’ overexposure to subprime mortgages could ultimately cost the financial sector hundreds of billions of dollars. The resulting loss of liquidity has tightened lending standards for both institutions and individuals. Declines in housing prices, which for years rose much faster than many people’s ability to pay, coupled with speculative bets on ever-higher house prices have pummeled the residential real estate market (nearly 6 percent of mortgages were past due in the first quarter of 2008).
Crude oil at record high levels in the $110 a barrel range is another culprit, along with a U.S. dollar that has dropped below $1.50/euro. Declining corporate profits, higher inflation, sagging consumer confidence, and anemic retail sales have added to the worries. Perhaps most damaging to investors’ psyche is uncertainty; no one knows for sure how much money the big banks will ultimately have to write off, or whether another Bear Sterns is just waiting to happen.
The problem with subprime mortgages wasn’t simply that default rates rose beyond what models had predicted; it was the highly leveraged bets that some hedge funds and investment banks placed on derivative products such as mortgage backed securities (MBS) and other structured credit products that used leverage to enhance returns. When defaults rose, it was the leverage that brought about several undesirable consequences: Since the repayment of the leverage was expected to be funded from payments on the underlying mortgages, when subprime borrowers defaulted, these leveraged instruments in turn failed to meet their scheduled payments to investors. In the repricing of risk that ensued, there has been a ripple effect as investors have rushed for the exits, and there has been a withdrawal of liquidity from the marketplace as financial institutions have stiffened their credit standards and made provisions for bad debts.
Perhaps most ominous, the lack of clear valuation techniques for these complex leveraged instruments, and the lack of disclosure with respect
to their presence in financial institutions’ portfolios, has made banks and investment banks reluctant to engage in the day-to-day purchase of each other’s short-term paper that is the basis for the underlying liquidity of the credit system. While the Federal Reserve has attempted to ameliorate the situation by making its borrowing facilities available to a much wider variety of financial institution than in the past, it is far from clear whether this alone will be sufficient to remove the sand that has clogged the wheels of the credit engine.
Positive Factors: Indicators for Investment Strategy
If the financial news were all bad, we’d be a lot worse off than we are. There are just enough positive factors out there to counterbalance the worries. For instance, earnings held up surprisingly well in the quarter ended Dec. 31, 2007. And some argue that valuations in the stock market are truly compelling. It was a seriously overvalued market in the wake of the dotcom bubble that led to the 2000-02 bear market. By comparison, valuations in today’s market—measured by the P/E ratio of the S&P 500—are in the normal range. And the aforementioned VIX Index, despite the recent increases, is nowhere near the levels of 2001 and 2002.
So how should institutional investors approach today’s volatility?
Optimize timing. For those who are confident that they can time the markets, wild swings can be rewarding. A healthcare organization’s investment manager can enrich the institution if his or her timing is perfect. Or the manager can very quickly make the institution feel impoverished. Most investment managers would probably be wise to eschew this approach.
Take advantage of the luxury of a longer time horizon. A more prudent approach may be to step back and recall that the next bull market is built on the volatility of the current market. Volatility can, indeed, create buying opportunities for skilled stock-pickers with a long-term horizon. And healthcare organizations have time in the market working strongly in their favor.
This advantage can be termed time-frame arbitrage—that is, the advantage the investor has to exploit market opportunities because the investor has a longer time horizon than most market participants and is willing to commit capital for long periods of time. It is the excess return (i.e., alpha) from investing in and thereby providing liquidity to the less liquid, less efficient sectors of the capital markets that has created the greatest opportunity for long-term investors to reap gains from assets that may, because of their illiquidity, be temporarily mispriced.
In many instances, the best way to exploit time-frame arbitrage is through alternative investments. Venture capital, private equity, distressed debt, natural resources, and real estate are all less liquid and less efficient and have very long-term horizons. The same holds for many marketable alternative strategies where long “lock-ups” force investors to have staying power and focus on long-horizon investing.
Reconsider asset allocation. Rethinking asset allocation is another opportunity for investors to potentially offset market volatility, and it is an approach that warrants particular attention. In an effort to construct and maintain diversified portfolios, institutions may risk spending too much time “checking boxes.” There is a tendency to focus too much on diversifying among asset classes that are, in effect, nondiversified. This approach, instead of reducing portfolio volatility, actually increases it.
One thing that is clear in today’s marketplace is that skilled managers are beginning to converge in their approaches to investment management. We see hedge fund managers doing private equity or real estate managers doing hedge funds, for example. As a result, highly skilled investment managers tend to move to those parts of the capital structure where they see opportunity to add value. But if they don’t fit into a style or strategy box, the investor doesn’t hire them because they don’t meet the asset allocation requirement.
It’s also fairly safe to observe that globalization has reduced the diversification benefit from international equities and emerging markets. Arguments in favor of the diversification benefit that held up pretty well in the early 1980s are less applicable today because of the integration of global markets. Money gets moved with the flick of a switch. The diversification benefit has not disappeared—especially when you take the currency benefit into effect for U.S. investors in an era of dollar weakness. But it has diminished.
In rising markets, one would want correlation between the U.S. and foreign markets. In fact, a closer look discloses that there is less correlation between the U.S. and foreign markets in up markets than there is in down markets. In other words, when the United States or the world catches cold, most equities go down. To this point, from February 1976 to January 1984, the correlation of the S&P 500 Index and the MSCI World ex-U.S. Index (in U.S. dollars) was 0.05 in up markets and 0.22 in down markets. Today, the correlation is quite a bit closer. From February 2000 to January 2008, the same correlation was 0.60 in up markets and 0.74 in down markets.
Asset Allocation: A Four-Layer Approach
It might be most useful for investors to think about asset allocation in four layers: assets, liquidity, currency, and risk.
Assets. A review of assets should take stock of the organization’s exposure to various markets—equity, fixed income, real assets (typically inflation hedges), and absolute return (strategies that generate a positive return that is uncorrelated with liquid markets).
Liquidity. Considerations of liquidity should entail determining how much of the portfolio will be committed to assets that are illiquid, or that have liquidity that is quarterly, monthly, or daily. A good definition of liquidity might be: “the ability to get out of a position at a reasonable price over a given period of time.”
Currency. The key point to consider here is how much of the portfolio is denominated in U.S. dollars and how much is in various foreign currencies representing Europe, Asia, and Latin America. Investors need to know their currency exposure because currency and the underlying markets will probably not move in the same ways.
Risk. Investors should assign risk values across the portfolio. An effective approach is to use four types of value at risk (VaR), a measure of the maximum expected loss over a specific period of time at a given confidence level. These types, each of which describes a different aspect of market risk in the portfolio, are:
- VaR (e.g., maximum loss that can be incurred in a trading day with a 95 percent confidence level)
- Marginal VaR (e.g., the contribution of a specific position or asset class to the total risk)
- Relative VaR (e.g., a measure of how closely a portfolio’s risk matches that of its corresponding benchmark, such as the S&P 500)
- Conditional VaR (e.g., the risk of loss in excess of that calculated by the VaR for a given confidence interval—a measure of ‘tail risk’)
This approach is four-dimensional diversification, instead of the standard one-dimensional diversification-by-asset-class-only approach. Once again, reiterating the time-frame arbitrage advantage of perpetual investors, this type of top-to-bottom diversification holds more potential for smoothing the rocky road that investors have been on for the past several months.
A Final Tip: Control Your Amygdyla
No discussion of market volatility would be complete without touching on plain old emotion—i.e., fear. For those times when things are really going haywire, it is helpful to keep in mind the perspective advanced by Jason Zweig, a senior writer for Money magazine, and a guest columnist for Time magazine and cnn.com, in his book Your Money and Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich.
Zweig writes about the amygdala (ah-MIG-dah-lah) located deep in the center of our brains. When one confronts a potential risk, this part of the reflexive brain acts as an alarm system—generating hot, fast emotions like fear and anger that it shoots up to the brain like warning flares. A television broadcast from the floor of the stock exchange on a bad trading day combines a multitude of cues that can fire up the amygdala: flashing lights, clanging bells, hollering voices, people gesturing wildly. Because the amygdala is so attuned to big changes, a sudden drop in the market tends to be more upsetting than a longer, slower—or even a much bigger—decline.
Fear of financial loss always lurks within the normal investing brain—you can’t change the biological facts. The response of the amygdala doesn’t make us irrational. But selling your investments every time they take a sudden drop will make your broker rich and leave you poor and jittery. Being prepared in advance and keeping one’s sights set on long-term goals can help keep that flu from becoming an all-out case of pneumonia.
About the Author
Dennis Doody, CPA, is managing director, Healthcare, for Commonfund, Wilton, Conn., and a member of HFMA’s New Jersey Chapter (ddoody@cfund.org).