Keys to Effectively Manage Risk Throughout a Market Cycle

Even as equity markets continue to make all-time highs, risk management remains one of the most important elements of the investment process. Coupled with the lasting impression of a former crisis – for today’s investor, the Global Financial Crisis – investors often make the mis­take of treating all draw downs in risk assets as a crisis-sized event.

While data shows that there is a significant equity market downturn every 7-8 years on aver­age, we often suffer from several smaller draw downs in the interim that are not cycle-ending bear markets. Preparing portfolios to weather these intra-cycle corrections, which are relative­ly modest market downturns of higher frequency, can be key to keeping clients on track.

A tactical approach to portfolio management coupled with adequate diversification can pro­vide insulation from market fluctuations, while also offering risk mitigation in market draw­ downs, return enhancement in strong markets, and a smoother ride overall.

Here are three considerations for building an “all-weather” risk management strategy:

1. Portfolio protection strategies are not one-size-fits all.

According to our research, 80% of equity market draw downs greater than 5% are actually more intermediate in nature, ranging between 5% and 20%. During the large market corrections, when equities lose more than 20%, asset classes such as bonds, defensive commodities, and currencies have done the best job protecting investors.

However, there is no consistent pattern to protect investments during the smaller, intermediate downturns. For example, in periods where central banks are enacting tighter monetary policy, sovereign bond and equity prices could go down in tandem for some time, negating any diver­sification in an investor’s portfolio.

Portfolio protection during intra-cycle corrections will be related to economic conditions, pol­icy response, and market sentiment at that specific point in time. A sound tactical approach will improve an investor’s probability of success in navigating periods of stress.

2. Going for cash may cost you. Diversify instead.

While the certainty of cash is appealing, especially during market corrections, investors often suffer the ill effects of being under-invested when markets bounce back after a downturn. Data shows that these intra-cycle downturns tend to happen fast and recover quickly, underscoring the importance of remaining invested. In our view, it’s better to temper risk while staying fully invested and adequately diversified.

One key to helping investors weather the storm is to maintain the proper mix of assets accord­ing to the investor’s risk tolerance and time horizon. This goes a long way towards mitigating portfolio volatility during periods of stress. Additionally, investors should have a portion of their allocation dedicated to a more tactical approach. Having the flexibility to tactically rotate, or even exit, market segments can add another layer of risk mitigation and help smooth out the ride over the long term.

3. Leverage the breadth of the ETF Universe.

ETFs provide a liquid and transparent vehicle to access global markets. With over 1,900 US listed ETFs spanning $3.8 trillion of assets under management, the investor now has unparal­leled flexibility to construct a low cost, well balanced portfolio.

The ETF marketplace offers a tremendous amount of tools to protect portfolios. This includes more traditional risk off asset classes such as core fixed income, commodities, and currencies, along with efficient access to a variety of defensive sectors. Additionally, ETF Sponsors have launched low-volatility equity ETFs designed to provide diversified exposure to lower volatili­ty US and international market segments.

Despite temptation to target risk management around only the largest market downturns, a well-rounded risk strategy will help you weather any storm.

For more detail, check out our Asset Allocation Perspectives video here.

 

Sage Advisory Services, Ltd. Co. is a registered investment adviser that provides investment management services for a variety of institutions and high net worth individuals. This report is for informational purposes only and is not intended as investment advice or an offer or so­licitation with respect to the purchase or sale of any security, strategy or investment product. Investors should make their own decisions on investment strategies based on their specific investment objectives and financial circumstances. All investments contain risk and may lose value. Past performance is not a guarantee of future results. For additional information on Sage and its investment management services, please view our web site at www.sageadvisory.com, or refer to our Form ADV, which is available upon request by calling 512.327.5530.