Volatility spikes are usually associated with sharply falling markets, and this was certainly the case for the S&P500 Index where at one point, during the first half of February, was down by more than 10% for the month. This brought back the familiar memories of the Global Financial Crisis that began in late 2007 of how suddenly turbulent the markets can become.
The recent jump in volatility was initially sparked by the release of a strong US jobs and wage data report that instilled fears that inflation may rise faster than expected. This would mean, in order to attempt to control inflation, central banks would need to tighten monetary conditions by raising rates at a faster pace than previously indicated. Subsequently, US Bonds fell sharply in value as yields rose to multi year highs. Adding fuel to the fire, a number of intricate investment products that were structured to benefit from low market volatility, often referred to as “short-VIX” funds, simply imploded as the sudden pick up in volatility meant many were written down to zero, further exacerbating equity market turmoil and increasing investor nervousness.
The reality is that extreme bouts of volatility, while rare in occurrence, should be expected when investing over the long term. Markets tend to move in cycles and can experience periods where conditions and investor sentiment seem to be significantly disconnected from fundamentals. During 2017, markets have delivered exceptionally strong returns and faced relatively low volatility, encouraging complacent behavior that has made equities increasingly more expensive. Expectations of a looming correction have been building up for some time and while the volatility spike in February was the first major one in a while, with markets continuing to trade at high valuations, we can expect volatility to remain elevated.
How to handle volatility
1. Keep calm, take stock and carry on
In the short term there isn’t much investors can or should do about volatility, other than taking a closer look at who they are investing with, what they are investing in and ensure this matches their appetite for risk.
“While we actively manage our funds with a long-term view, we monitor markets and our holdings closely to react to any changes when necessary. We focus on a concentrated selection of quality companies with sustainable business models and solid fundamentals, rather than getting distracted by market turbulence and noise,” says Andrew South, Investment Manager at QuayStreet.
2. Diversification, the only free lunch
It is during times of volatility a diversified portfolio across different asset classes, sectors and geographic spread makes a big difference. Having exposure across many different types of securities can help reduce the overall volatility of the portfolio.
3. Hold cash to take advantage of opportunities that arise
The level of cash a fund can hold is an important consideration as it can dictate the level of flexibility an investment manager has in taking advantage of extreme market fluctuations.
“We have viewed the equity market as being over-valued for some time and have held an overweight cash position. This enables us to deploy and respond to attractive buying opportunities when markets are going through periods of weakness, as they have recently,” says Andrew.
Investing for Income
The Income Fund invests in a range of income producing securities and has holdings spread across Australasian markets, issuers, sectors and maturities to provide diversification.
“A key advantage of the Income Fund is the ability to change the exposure to fixed interest rates in response to changing market conditions. This is very different from a bank term deposit where the interest rate is generally locked in until maturity and there is a penalty to withdraw money early,” explains Roy Cross, Income Fund Investment Manager.
Where to from here?
It is impossible to say when the next period of volatility will hit. However, for long-term investors this shouldn’t raise any concerns. Rather than fearing market jitters, investors should welcome these as opportunities to find good value across markets.
Risk and return always go hand in hand and some volatility is expected if you are looking to achieve higher long-term returns. No matter how a portfolio is constructed, there will always be an element of risk. The key is to know your tolerance to market fluctuations and ensuring you are in the right fund that satisfies your investment constraints and objectives.