Quick Q&A: Risk Management in Volatile Markets
Investors should prepare as markets already are past the inflection point of volatility.
It looks like more volatility is on its way. The traditional ways of reducing volatility may mean investors must leave precious performance on the table, so investors should be prepared with some alternative ideas for the changing market. Head of Quantitative Strategies Michael Hunstad, Ph.D., discusses what investor should look for.
Q. Can investors determine if they’re prepared for risk going forward?
A. Investors became somewhat ambivalent about risk during the long period of low risk, low volatility, and high returns — it almost didn’t matter how much risk you were taking. Going forward, that is all changing. So, the first step to determining if you’re ready for what’s coming is to determine the source of risk in your portfolio. Is it asset allocation, or within the asset class itself? The most important consideration today is the risk within the asset class. If you are dominantly exposed to risk you aren’t compensated to take, you aren’t really prepared for what’s ahead.
Q. Are we at a market inflection point?
A. From the real side of the economy, no. Our view is that over the next five years we will not be entering a recession. But, keep in mind that even if the real side remains relatively stable, the volatility of the markets doesn’t necessarily behave the same way. Are we at a volatility inflection point? Absolutely. We’ve already passed that inflection point. The future will be very different from the past, so that inflection point is critical in thinking about how you’ll prepare portfolios for solid but muted growth going forward, accompanied by a lot more volatility.
Q. How is the future going to look different from the past?
A. We’ve seen a rise in realized volatility and more dispersion in sectors and country returns, for example. There are a lot more elements of risk operating under the hood. This creates issues, especially for actively managed strategies within the fixed income or equity space. For example, the markets had a little higher volatility last year, but there was tremendous sector rotation.
January and February were completely risk-on, and we saw the cyclical sectors outperform the defensive sectors by as much as 900 basis points. In March, that all shifted around — it was a mirror image, with the defensives outperforming the cyclicals by about the same amount. All of this, while on the surface the markets seemed relatively calm. In a similar scenario going forward, if you aren’t cognizant of that sector rotation, you could be whipsawed.
This Q&A is from Northern Trust Asset Management’s Special Report The New Way to De-Risk in Institutional Investor. Click here for the full report.
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