Tactical hedging and strategic diversifying
12 November 2019
By Gerald Moser, London UK, Chief Market Strategist
With uncertainty set to stay elevated in 2020, adding value through hedging strategies and diversifying away from equities and fixed income seems to make sense.
As highlighted often in our Outlook 2020 report, arguably the main topic for markets is likely to be uncertainty. Although uncertainty is difficult to deal with when making investment decisions, we think that there are solutions that can help investors.
As highlighted in the Yield enhancers article, volatility can be used to generate a steady stream of returns through systematic selling of volatility. But in periods of uncertainty, there will also be times to use volatility to hedge opportunistically when the cost/benefit of doing so looks sensible.
As the timing of any sell-off or risk-off episode is uncertain, we see more value in staying invested and using cost-efficient hedging, rather than staying on the sideline and losing value to inflation from holding cash.
Ramping up uncorrelated returns
We also see value in increasing exposure to asset classes, or strategies, that are less correlated with equities and fixed income. In this late-cycle environment, and with the additional layer of geopolitical uncertainty, diversifying exposures or adding assets that have more fundamental drivers, and are less sentiment driven, are steps that should add value in portfolios.
We see several ways to add value. First of all, we continue to like gold as a diversifier in a portfolio. While we do not expect a recession in 2020, risks are increasing and uncertainty is high. Gold has historically been one of the most effective hedges during periods of equity drawdowns.
Second, private markets can be another potent diversifier. Adding private capital to a portfolio has historically decreased risks and improved returns (see chart). Private capital funds usually focus on particular fundamental drivers: the thorough due diligence advisable before making an investment implies that the value of this investment is primarily derived from a company strategy rather than top-down considerations. The illiquidity nature of the asset class also means that shifts in risk sentiment have less impact on private investments than on public markets.
Finally, we see opportunities to diversify in public markets using alternative strategies, such as market neutral or merger arbitrage. Those strategies should only be partially correlated with markets as they tend to focus on fundamental discrepancies arising from a particular situation, such as takeovers. Over time, there should be a pull to realise fundamentals, with little impact arising from top-down drivers.
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