In fact, eight in ten institutional investors surveyed in late 2018 expect volatility2 in 2019 and say current conditions favor active management.3 Institutions’ current allocations are split 70% active and 30% passive and gave no indication of making a shift anytime soon. They cite interest rates (56%) and volatility spikes (52%) as key portfolio risks for 2019. More than half of the respondents say dispersion (variances in the co-movement of security prices) will increase in 2019, which is one reason many may be focused on active management. Unlike passive investments, active strategies have the potential to capture select opportunities caused by pricing anomalies during market downturns, as well as the ability to manage risk in portfolios.
Active management matters more
Source: Natixis Investment Managers, Global Survey of Institutional Investors conducted by CoreData Research in October and November 2018. Survey included 500 institutional investors in 28 countries.
Chief Market Strategist at Natixis Investment Managers, David Lafferty, isn’t forecasting a US or global recession for 2019 – as consumer consumption is being supported by strong employment trends in many countries. However, he is expecting risk assets to weather a modest economic slowdown with some speed bumps. “There may be a bit more room for risk assets to run higher, but a slowing global economy argues for caution. Greed isn’t likely to be rewarded this late in the cycle, so investors should seek lower-risk ways to construct their allocations,” said Lafferty.
Rising rates fuel new risks
After ten years at or near zero, interest rates are gradually rising, and presenting a new risk challenge. In December, the US Federal Reserve’s policy-setting Federal Open Market Committee moved its interest rate target from 2.25% to 2.50%, and two more hikes are projected for 2019. According to the Natixis Global Survey of Institutional Investors, institutions believe the pace at which hikes are implemented (53%) matters more than the level of the hikes (27%). For example, if rates rise too fast, it could result in a significant jump in inflation and especially wage inflation, which could cool markets and make return assumptions less realistic. Lafferty is also watching for inflation signals. “We believe inflation to be under control for now. If this proves incorrect and inflation rises more vigorously, the Fed will find it harder to pull back, nominal rates will rise (not fall), and consumers will feel the pinch,” he said.
Active pursuit of a yield advantage
Duration decisions will be very important in 2019 as interest rates are in transition, according to Matthew Eagan, Fixed Income Manager on Loomis Sayles’ Strategic Alpha and Multisector Full Discretion teams. “I do think as the rates rise more, a big decision we have to make in the not-too-distant future will be when to increase duration in our portfolios,” said Eagan.
Heading into the new year, he and his team members think it makes sense to lean in on credit risk and away from interest rate risk. “I would rather be short on duration4 and wrong than long and wrong given low rates and increasing Fed rates. Within credit, we can really rely on Loomis Sayles’ deep research capabilities to selectively reach for yield,” said Eagan. He points out that at this late phase in the cycle, security selection becomes even more critical for generating alpha5 because credit spreads6 are tight and yields are low. Integrated bottom-up research provides his team with the confidence they need to take prudent risk and be patient, value-oriented investors.
One of the more favorable places to invest today, he believes, is US high yield. “The economy is doing well, corporate profits are good, credit fundamentals are solid, and we think default rates are going to remain very subdued over the next couple of years. With duration on the shorter end of the spectrum, this asset class is less sensitive to upward pressure on rates,” said Eagan.
Non-traditional routes to income diversification
Eagan believes the active approach of both Strategic Alpha and Multisector strategies can provide investors with flexible frameworks to pursue opportunities across global markets and pivot away from perceived risks. Both are benchmark agnostic and can work as diversifiers to traditional bond portfolios.7 “In comparison, Strategic Alpha is really an all-weather strategy designed to provide attractive risk-adjusted returns throughout market cycles8 while focusing on drawdown management and low correlations to traditional fixed income,” said Eagan. Loomis Sayles’ Multisector strategies take an opportunistic, go-anywhere approach, identifying undervalued bonds with favorable current yield and strong prospects for price appreciation.
“Overall, both strategies emphasize investments with strong underlying fundamentals and yield advantage. With the security selection expertise we have at Loomis Sayles, we believe we are well positioned to deliver on that,” said Eagan.
Options to dampen stock volatility
While sharp swings in the stock market can make investors lose confidence, volatility is not all doom and gloom, says David Jilek, Chief Investment Strategist at Gateway Investment Advisers. His firm’s low volatility equity strategy has used index options9 to help reduce the risk of equity investing for more than 40 years. “We would rather the market go up than down. But we are more comfortable in this type of environment than many investors because the tool we are using to help manage risk can become more effective,” said Jilek.
The Gateway approach is designed to provide the majority of returns associated with equity market investments, but with less risk. It invests in a broadly diversified portfolio of stocks that closely tracks the US equity market, while hedging the portfolio with index call10 and put options.11
Because volatility is cyclical and the option market tends to overprice volatility, Jilek believes it’s times like these when hedging with options can be particularly useful. “Because you can get more cash flow from option writing when volatility ticks up, that can help deliver more protection if a market downside of any magnitude materializes – but also higher volatility and increased cash flow can also provide attractive participation if the market trends up,” he added. Overall, Gateway’s options-based strategy looks to harness the long-term growth potential of the equity market but smooth out the ride.
The views and opinions expressed are as of February 11, 2019, and may change based on market and other conditions. There can be no assurance that developments will transpire as forecasted. Actual results may vary.
All investing involves risk, including the risk of loss. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments.
Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated.
1 A repetitive succession of changes in economic activity. The typical business cycle has four phases: expansion (recovery), peak, contraction (decline), and trough.
2 The range of variation in the value of a security.
3 Natixis Investment Managers, Global Survey of Institutional Investors conducted by CoreData Research in October and November 2018. Survey included 500 institutional investors in 28 countries.
4 Duration: A bond's price sensitivity to interest rate changes.
5 A measure of the difference between a portfolio's actual returns and its expected performance, given its level of systematic market risk. A positive alpha indicates outperformance and negative alpha indicates underperformance relative to the portfolio's level of systematic risk.
6 A credit spread is the difference in yield between a U.S. Treasury bond and a different debt security that has the same maturity but also has a lower credit rating.
7 Diversification does not guarantee a profit or protect against a loss.
8 The movement in a market's price level from a peak through a decline of at least 20% and recovery back to the peak level or higher.
9 Index option (European-style expiration, cash settled and exchange-traded): an option contract on an index (e.g., S&P 500) in which the buyer (owner) pays a cash premium up front to the seller (writer) of the option. If at expiration, the option contract is in-the-money, the seller pays the owner cash in the amount of the difference between the option strike price and the current value of the index; otherwise, the option expires worthless for the buyer and the seller keeps the full premium received up front. The writer of an option is paid a cash premium for taking on the risk associated with the option obligation to pay if the option expires in-the-money. Listed index option contracts can be closed or traded prior to expiration date, but not exercised.
10 Call options can reduce the risk of owning stocks, but they can limit returns in a rising market. The fund's use of options in managing volatility or in the pursuit of investment returns may not be achieved.
11 The buyer of a put option has the right to sell an asset at an agreed-upon price (“strike price”) within or at a specified time. The seller of the option has the corresponding obligation to buy the asset at the strike price if the buyer exercises the option within or at the specified time. The buyer of a put option risks losing the amount paid for the option if the price of the asset does not fall below the strike price. The seller of a put option risks losing the difference between the asset’s price and the option’s strike price, less the amount received from the sale of the put.