This week Robert Swift, the Head of Global Equity Strategies of the TAMIM Global Equity High Conviction Individually Managed Account (IMA), talks about volatility and why it is an opportunity as much as a threat. We hope to reinforce the idea that portfolio management is more than simply “picking stocks’. Identifying mispriced stocks is a part of it but position sizing, measuring and identifying aggregate risk exposures, and knowing why and when to buy and sell are all part of it too.
Investing through Volatile Markets
Robert Swift – Head of Global Equity Strategies
​- 10th August 2016 -
Recent equity market volatility (where stock prices have been swinging around), the continued rise in bond prices/fall in long term interest rates, the surprise vote for Brexit and the even more surprising positive market response to that vote, reminds us all once again that markets often seem to exist just to inflict ‘maximum pain’ on investors! Bonds were expensive yet have become more so and equities didn’t fall after Brexit like they were supposed to!
 
How should we cope with this? What can we do?
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We were reminded of a good analogy for investing by a former colleague when we visited the USA recently.  She recalled, at a conference that investing was like sailing. You have all the equipment you need; presumably some skill to be at the helm or in charge of your portfolio; and some knowledge of the near term market outlook (weather and tides) and current situation (wind, rocks etc). Additionally you should know where you are going; how fast your equipment can carry you; and have some plan to deal with unexpected adverse weather. This equates to time horizon, risk tolerance and asset classes you care to use.

Like investing, sailing is also a journey and you can’t stay in in cash (the harbour) for ever. 
It is imperative to plot a course and then stay the course, especially when it is stormy or volatile. The most dangerous thing to do in a sudden squall is to panic and try to fundamentally change course. In fact, regardless of the market squalls your course should always be to:
  • Devise a plan – know where you want to go and be and by what time. Income, risk etc
  • Remain diversified – seek stability and have all the sails ready in case you need them
  • Invest consistently and constantly – know how much risk (sail) to have out there at each part of the course.
 
It’s actually difficult to remain calm when you think you are losing, or likely to lose, money. We feel that too. One of the reasons we like to use quantitative models s part of our investment process is that they help us overcome our tendency to overreact; to let our emotions cost us money by buying or selling the wrong things at the wrong time. There is comfort in being in a crowd yet the crowd is often wrong. Effectively the quantitative models can help stop us trying to gybe in a hurricane and stay on course even if short term it looks dangerous.
 
It is these market gyrations that have prompted this update and we’re going to talk briefly about volatility and why it is an opportunity as much as a threat. We hope to reinforce the idea that portfolio management is more than simply “picking stocks’. Identifying mispriced stocks is a part of it but position sizing, measuring and identifying aggregate risk exposures, and knowing why and when to buy and sell are all part of it too.
 
When investors talk about volatility they can mean either that the market as a whole is going up and down in price more, and more often, or that individual stocks are behaving more wildly and independently. As an active manager you do want some individual stock volatility and for stocks to move in different directions and different speeds from each other. We can call this “market variety”. When the market as a whole is going up or down more this is an opportunity to time the market by being in cash at the right time or switching between asset classes at the right time. When market variety is high this can be an opportunity for an active manager to incur portfolio turnover and to refresh the portfolio and make it better. Many fund managers like to have hard target prices for their stocks they like and they do not sell until they have hit these targets. This is very suboptimal since the opportunity to make extra money from high market variety is being ignored. We believe turnover should be based on the opportunity provided by market variety and your skill in selecting within the market. It is not a simple question of a monthly or quarterly meeting to discuss stocks! This opportunity isn’t constant but varies according to “within market price volatility” also known as “cross sectional volatility” or “variety”
 
Let’s illustrate with the following examples. 
  • The stock market consists of two stocks of equal market size A and B.   Both are priced at $10 and are worth $12. The market as a whole is priced at $10 but worth $12 and is undervalued. After 1 year both trade at $12 and have moved in lock step with each other to $12. Consequently as an active manager it has been futile to prefer one stock over another. Any preference for one over the other would have been pointless. Money has been made by being in the market not by active stock selection.
  • The stock market now consist of two stocks of equal market size A and B but one is priced at $8 and the other at $12. Both are worth $12. The market is still worth $12 but there is clearly a benefit to having a bigger exposure to A than B. Active managers would choose A if they had skill at stock selection. After 1 year both trade at $12.
  • Now we introduce some market variety or cross sectional volatility. Let’s assume that the stock prices gyrate through the year but the valuations remain the same. Let’s also assume that the stock prices move independently of each other as investors change their mind about their perceived valuations of the companies. This represents the more likely real life scenario?   

A and B are priced at $8 and $12 but worth $12. At the end of one month A is at $10 but B is now at $8. They are still worth $12. What a manager should do is sell some of A and buy some of B even though A is below its initial target price or fair value. The prospective return for B to end year 1 is now higher at 50% than A which is 20%. The manager should buy B.

Let’s add another bout of volatility and stock B rises to $12 by end month 6 while stock A falls to $6. If nothing changes in the estimated valuation then the manager should be selling B to buy A based on the return time horizon.  
 
So what can we surmise from this?
  1. A manager who isn’t prepared to trade based on the relative price fluctuations of the stocks in the universe is not offering an optimal portfolio.
  2. Having a monthly or weekly stock meeting is not enough if the portfolio doesn’t change according to the market opportunity.
  3. Even perfect foresight is always redundant by changes in market variety.
  4. Managing portfolios is more than identifying a few stocks you like; follow closely; and then trade in and out of based on immutable target prices.
  5. A real world of hundreds of stock prices changing daily, unspecified return time horizons, uncertainty surrounding true relative returns and changing relationships requires skill, experience and some hefty investment in risk software.   

​In a following article we will argue that having more stocks to choose from makes portfolio management more problematical. There are more valuations to perform and more relationships to worry about but, paradoxically, it leads to better risk adjusted returns if you do it right and know how to use this greater market variety. Consider this. Australia has a few hundred stocks from which to choose. The global equity market a few thousand. Given the same level of stock selection skill, which universe will produce better risk adjusted returns?

Happy Investing,

​The team at TAMIM
https://www.tamim.com.au https://www.tamim.com.au