by Steven Hatzakis | Guest Writer
The negative side of volatility is the added uncertainty it introduces into markets. When markets are orderly and less volatile, investors feel more certain, whereas, when volatility increases the market outlook becomes less clear.
In addition, volatility poses a challenge to diversifying, since during periods of market turmoil and crisis, asset classes can become more correlated than when conditions are normal.
Diversification is not what it used to be. In the past, diversifying a portfolio across a few sectors and asset classes was enough to help remove any concentrated portfolio risk by spreading it across a variety of holdings and using different weightings for each allocation depending on clients’ needs.
However, variety doesn’t always equal diversification when it comes to portfolio construction, and especially when markets get turbulent.
A new approach using a basket of exchange traded funds (ETFs), which has been further popularized by robo advisors, tries to achieve the same diversified allocations across asset classes and sectors.
However, this may not reduce portfolio risk in a meaningful way for investors, as correlated securities – when coupled together – introduce additional variables of uncertainty over a portfolios potential performance, even when using inverted or negatively correlated holdings.
It’s important to note that the purpose of diversifying is not to create a hedge position which would reduce both potential risk and return, but instead reduce overall downside risk by making the portfolio dependent in the sum of its parts and not a single position.
A study by Columbia Management Investment Advisers found that low correlation contributes greatly to risk reduction when compared to portfolios with higher correlated holdings.
The challenge is that markets today are far more efficient and react to information at lightning speeds. These technology innovations have also brought about renewed definitions of risk, such as systemic events related to market crisis and recessions or a flash-crash rouge algorithm or human trader, or geopolitical events that cause volatility such as Brexit.
A shift from active investing to more passive investing may also reflect the improved market efficiency, as information about securities are reflected in their valuations as theorized in the efficient market hypothesis.
Nonetheless, a truly diversified portfolio even in today’s markets may be harder to achieve as electronic markets are highly correlated. Whether the correlation is positive or negative, even a portfolio with a large number of disparate holdings spread out sufficiently – could still be under the effects of a global market sell-off, simply because of the interconnectedness of markets.
The real economy, however, and the real assets that make up economies, are not as correlated to financial assets – or at least not as quickly, providing investors with a viable alternative investment opportunity into assets that would otherwise be considered alternatives when compared to traditional bank and brokerage products.
An outlook for the third quarter (Q3) from Goldman Sachs Asset Management (GSAM), highlighted that we may have entered a new phase characterized by more frequent market turbulence, as one of the themes outlined in its recent analysis.
Heather Kennedy Miner, Global Head of Strategic Advisory Solutions at GSAM, said “we think this challenging market reflects the uneven state of the global economic cycle. While major economies continue to grind out slow growth, in some respects, traditional cycle analysis has broken down. For instance, the US economic cycle is running behind and has helped to elongate the US credit cycle, we’re therefore in an environment where slow and steady growth is coinciding with heightened risk in credit markets.”
The outperformance of US stocks in recent years was described as unusual, as stocks become expensive near new record highs while trading at high multiples per share when compared to earnings.
Using data compiled by Bloomberg and GSAM, the chart below shows a wider band and less steep trajectory for the S&P500, indicating lower returns and higher ranges of price volatility.
“We still want to buy equity dips and sell rallies, but even post-Brexit volatility has not been significant enough yet to trigger a contrarian buy signal in our investment process,” said Andrew Pease, Russell Investments’ global head of investment strategy, as noted in a statement accompanying the company’s Q3 2016 outlook published in early July.
Mr. Pease added: “U.S. equities still look expensive, business cycle fundamentals in developed markets are weakening and government bonds score poorly on value.”
A business cycle index (BCI) model can be seen below for the US economy, from Russel Investments Q3 2016 Global Market Outlook, showing an increase in the probability for a recession over a 12-month period – versus a decline compared to shorter-term forecasts.
Such sentiment and observations – including about volatility, challenging market conditions, and when the next recession may start – are driving investors to explore alternative assets such as the real assets that exist outside of traditional financial products and assets.
In other words, [alternative investment] products not readily available at most banks or brokerages are being presented to investors thanks to new technology platforms that aggregate alternative assets through regulated channels.
Before exploring alternatives further, it’s helpful to understand the difference between real assets and financial assets, in the context of alternative investments, as explained below.
Real assets can include personal property, real estate, land, vehicles, planes, boats, machinery, and even knowledge in the form of Intellectual Property (IP), among other tangible goods.
The creation, trade and use of these assets contribute to the real economy, whereas, financial assets such as stocks, bonds, derivatives and other such securities represent the claims that investors have on how such wealth is allocated, distributed and exchanged.
Until recently, retail or institutional investors who can trade financial assets from their brokerage account online – would have to otherwise go offline to find any investment opportunities into real assets such as with private investors.
After all, investors want to invest in tangible assets and not just fiat-based paper, however, each can have its place in a well-balanced portfolio and depending on a customer’s needs and overall market expectations.
For example, owning property (a real asset) is not the same as owning shares (a financial asset) in a real estate investment trust (REIT), however, some may argue that there is a fine line where both sides converge – and depending on legal contract terms and definitions.
The important distinction with securities or bonds and other financial assets (when compared to real assets), is that the money that investors pay to purchase securities – is paid to the issuers as a form of financing (such as a loan) – and in turn the securities given to investors become a liability to the issuers.
Such opposing sides of a transaction can be seen on firm’s balance sheet as liabilities take up millions or billions of dollars from other line items including assets, as public companies report about their shares in their regulatory filings. Shareholders and bondholders have similar positions – it is just the product that is different and perhaps the viewpoint or context.
In other words, the issuing of shares carries obligations for the company to confer rights to the holders of theses financial assets, whereas investing or owning a real asset typically involves a legal contract or deed that conveys individual ownership in a similar way.
Historically, alternative investments may have only been available to ultra-high net worth (UHNW) investors or selective clients of large investment banks who were presented with structured finance opportunities in private companies or real assets outside of financial markets.
Such deals, which continue in the form of venture capital, private equity and other investment banking sanctioned activities, are not typically open to the masses.
The benefits of professional advisory services on selective investments, whether into real assets or financial assets are being brought to the mainstream by companies like Yieldstreet, thanks to its financial technology (FinTech), management expertise, and selective approach.
Combining real assets within a structured financial product with low correlation to the stock market, and attractive yield targets over the short and medium term, qualified accredited investors can participate alongside institutional investors in portfolios that are inherently diversified on their own, and know that their position is backed by underlying real assets.
Considering the rising risk in credit markets, potential uncertainty, and challenges for diversifying, finding asset-backed opportunities via the use of alternative investment platforms can provide investors with a means to truly diversify their portfolio risk from equities, bonds, and other financial assets.
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