Stock Markets Too Volatile? Get the Long and Short of It
Point of View With Raffaele Savi, Kevin Franklin and Paul Ebner
- Investors remain fearful of market volatility and hold fewer stocks than they should, given the need for meaningful growth and returns.
- A major reason for this reluctance is the exposure portfolios have to stock market volatility; reducing that risk can enhance the ownership experience for stock investors.
- A solution is to employ an investment strategy that seeks to take advantage of global stock market inefficiencies to profit in both up and down markets.
- A professionally managed stock portfolio that employs an active strategy to manage risks can help reduce volatility and enhance returns.
Why have investors moved out of stocks?
It's not hard to understand why investors remain cautious and underweight equities given the extreme volatility caused by the global credit crisis and subsequent European debt crisis. The chart [below] shows the significant maximum losses that investors endured from the global credit crisis, which led to a significant flow out of equities into bonds. It seems pretty clear that despite the recent stock market rally, investors are still looking for a better, less volatile, solution for the stock component of their portfolio.
Is there a better way to manage stock market volatility?
Many investors have been asking that question. Part of the problem has been that the stock portfolio strategies currently available are not built to manage market volatility. In fact, most equity funds are set up in a way that the investor ends up being exposed to all of the ups and downs of the market, with little to buffer the extremes. In addition, since 1997, equity sectors have moved together in bull or bear markets (see chart below), so what was thought to be diversity really was not. So what investors need is a stock portfolio that behaves differently than the broader market by taking a different approach. As a solution, we believe investors should consider a long/short equity strategy to help reduce volatility.
What do you mean by a long/short strategy?
A long/short equity investment strategy means that we buy (long) stocks that we believe will appreciate in price, and at the same time sell (short) borrowed stocks we believe will go down in price. The intention of shorting is to buy the same stocks back at a future date for a lower price, profiting from the difference. Whether markets are rising or falling, this kind of portfolio strategy is designed to profit from stocks that go up and down, providing results that are different from traditional US and international equity markets.
A dedicated long/short approach is an effective strategy to try to take advantage of the inefficiencies of global stock markets. By matching both long and short equity positions, we have the ability to dial up or down our exposure to market risk from 0% ("market neutral") up to 40% exposure. This means we seek to deliver excess returns out of our investments, while minimizing our exposure to broader market movements, and the related volatility. Investors should note that long/short strategies present the possibility of significant or total losses, and that the long and short strategies may not perform, potentially adding to volatility and losses.
What are the benefits of this approach?
A key benefit of a dedicated long/short approach is the increased number of opportunities available to us. In so doing, we are able to pinpoint precisely the companies we believe will perform well, even if we don't favor the industry they participate in. It's that herd mentality that we're working to defend against. We believe this kind of strategy can offer portfolio growth with less volatility.
Conventional wisdom is that developed stock markets efficiently and quickly price stocks based on fundamentals. The reality is that pricing inefficiencies occur all the time.
You suggest developed stock markets are inefficient. How?
Inefficiencies exist in every market. Conventional wisdom is that developed stock markets efficiently and quickly price stocks based on fundamentals. The reality is that pricing inefficiencies occur all the time; they just don't stay around for very long in developed stock markets. But opportunities exist--frequently when the connections aren't obvious or direct. So investors must find ways to enhance their understanding of the fundamentals and relationships surrounding companies to uncover those opportunities and stay ahead. The way we look at it is when a balloon is squeezed smaller at one end, it expands somewhere else. We see that in stock markets: when one inefficiency is eliminated, somewhere else a new opportunity arises.
Ultimately, what we're trying to do is capture the ripple after a stone drops in the water. Although we may not be able to predict where the stone drops, we can forecast how we think the ripples will play out.
What advantages do you have to capture these opportunities?
We believe information is our advantage: specifically our tools for accessing it, consuming it and analyzing it. That leads to better investing. To take advantage of the vast amount of publicly available information available, we believe a scientific approach is necessary to process it all and make sound trading decisions. The benefits of our scientific approach include being able to bring a technological edge as well as continuous evolution to our investment process.
For example, our access to information relies on cutting edge infrastructure to compile vast amounts of obvious and less-obvious sources of publicly available information. In fact, we consume a massive amount of data from more than 25 countries, with a storage capacity 4 times the Library of Congress and 8 times the size of Wikipedia. We take that vast quantity of publicly available information and filter and identify relevant pieces.
The numbers are big--new information is mapped to more than 1.7 million entities and 100 million connections--but it is how we synthesize it that is a key advantage. We analyze and interpret this vast array of data to provide daily rankings and updates on the over-2,500 companies we follow, allowing us to make high conviction investment decisions.
Can you give us an example?
One example is a case in which we tried to take advantage of the reviving housing market. (See example 1) We were interested in a less-obvious company that could present a stock buying opportunity. In this case, we relied on a map of relationships we built to understand the housing industry. Our mapping system led us to the less-obvious opportunity, but one that is central to a housing rebound: a company that produces titanium dioxide. Housing? Yes--titanium dioxide is primarily used to improve the whiteness of paint.
Can you provide another example?
Another example is when a for-profit education company was mentioned negatively in a Congressional hearing and US GAO report. (See example 2) Immediately the stock dropped. Few investors could take advantage of that surprise. But we believed there would be other connections that might take longer to be uncovered. We systematically uncovered the less-obvious education industry connection in a software company that sold its online content delivery system to several major for-profit firms, resulting in a successful short-sale opportunity that developed over a period of weeks following the initial news.
If inefficiencies disappear, how do you find new opportunities?
Evolution is central to our process. We maintain our edge by continuously evolving our investment research strategy. Because finding the less-obvious investment opportunity requires resources and skill, we are constantly investing in our technology, expertise and people to maintain our competitive advantage.
We continually are looking for more and better public information about companies, ways of knowing it sooner and improving our understanding of that information. Indeed, over the course of 16 years, our team has changed and evolved the inventory of hundreds of signals and investment classifications to stay ahead of market changes. For example, our ability to consume research reports, conference calls and filings has gone through three generations of improvements.
Can you describe your team's investment process?
The Scientific Active Equity team has managed long/short portfolios since 1996. We have team members in Asia, Europe, Australia and the US so the sun never sets on our ability to monitor and trade markets. Our investment process is built around this flexible global team and based upon a systematic application of our research based on three buckets: earnings quality, sentiment and relative valuation. Combining these factors offers us a comprehensive view of how likely it is that a given stock is going to outperform (or underperform) its peers over the next three to 12 months.
How should investors incorporate this strategy into a portfolio?
We believe this strategy is a great building block for meaningful diversity in a broader portfolio of stock funds, particularly in a tax-efficient account. The portfolio illustration to the left shows how this building block can be combined in a broader equity and fixed income portfolio. By incorporating a long/short strategy into a traditional equity portfolio, investors can help reduce volatility and enhance returns in their overall equity portfolio.
For investors looking to add more growth potential:
- Increases exposure to equity-like returns, but with low volatility
- Low correlation creates a nice complement to traditional equities
For investors under-allocated to international equities:
- Increases exposure to global equities, but with less exposure to global market risk
- Low correlation complements US equity holdings
Investors preparing for retirement:
- The higher potential returns of equities than what is currently offered by investing in bonds can enhance a retirement portfolio
- Increases exposure to the growth potential of equities, but with lower volatility
About the Author
Related by Topic: Equities, Alternatives
Jeff Shen & Rodolfo Martell
The case for investing in emerging markets in compelling, but recent performance challenges can make the positives easy to overlook. Jeff Shen and Rodolfo Martell introduce an approach that seeks to balance the risks and rewards inherent in EM investing.
Chart of the Week
Emerging markets represent only 12% of total world stock market capitalization, meaning ample room for growth for investors.
51%: Emerging markets' share of world GDP
Our view on EMs? In a nutshell, we like 'em. Read more here.
Luiz Soares & Jeff Shen
Emerging markets can represent an attractive asset class for investors seeking returns and diversification. BlackRock's emerging markets experts discuss opportunities, misconceptions and ways of incorporating the asset class into your portfolio.
What's in store for 2014? Russ Koesterich, Jeff Rosenberg & Peter Hayes offer their 10 best ideas for the year ahead in the 2014 Outlook: The List, consisting of 5 "what to know" items and 5 "what to do" ideas to help you navigate the markets.
Economic growth shows (slow) signs of improvement, and while structural issues remain, Chief Investment Strategist Russ Koesterich believes early 2014 is the most likely timeframe for the Fed to start tapering.
Chart of the Week
Most investors fear rising interest rates. Which begs the question – are there alternatives to bonds that might offer income and behave better in a rising rate environment?
What should investors expect in 2014? The Investment Strategy Group provides its take in this annual outlook special edition of Investment Directions.
It's easy to lose your composure when markets misbehave. But staying grounded today can reap rewards down the road. Read our seven tips for managing through manic markets.
Stock markets have been on a tear, but it's not too late to participate. BlackRock investment pros offer insight on the opportunity in equities.
The data indicates U.S. investors are under-allocated to international stocks by as much as 50%. Are you missing out on a world of opportunity?
You've anticipated retirement for years. When the saving is done and it's time to take income, how will you know if you're ready? Meet CoRI.
Stuart Reeve & Andrew Wheatley-Hubbard
Three concerns weigh heavily on investors' minds today: slow growth, high volatility and low (but unsettled) interest rates. The BlackRock Global Dividend Team discusses how high-quality, dividend-growing stocks may help.
While the Fed's no-taper decision may delay rising rates, we expect that rates will rise moderately over the next two to three years. In this week's video, Russ Koesterich offers his suggestions for positioning equity portfolios in preparation.
The United States is likely on the verge of an energy revolution, with meaningful implications for the economy and investors. The BlackRock Global Allocation team shares some observations.
BlackRock's best recommendations for the current investing environment.
You've got questions, we've got answers. . .at least four, on the topic of target date funds.
Times change, and like most of us, you probably update your fashion, technology and maybe even your diet and musical interests to keep pace. Can you say the same about your financial strategies? See if you're up-to-date or behind the financial times.
Earlier this year, portfolio managers of the BlackRock Global Allocation Fund sat down in a live webinar to interact with investors. Missed it? Get the recap.
When it comes to investing, the fastest sprint doesn't necessarily make you a winner. Portfolio managers of the BlackRock Equity Dividend Fund discuss why they believe slow and steady wins the investing race - particularly during volatile times.
Emerging markets have been the dominant growth story of the past generation. As the cycle evolves, so must the investment approach. The BlackRock Global Allocation team offers five thoughts for investing in emerging markets today.
Value remains an important priority for Americans today. BlackRock's Bart Geer believes that same mentality should apply when constructing an investment portfolio.
Munis have long been a source of high-quality, low-volatility income. That's true to this day, but BlackRock's Peter Hayes explains why 2013 will not be exactly like 2012...or 2011.
With Washington finally coming to a limited agreement to prevent (or delay) the fiscal cliff, BlackRock offers our thoughts about the economic and investment implications.
The votes have been cast; now the hard work begins. In a new report, BlackRock discusses the key challenges and other market implications of the US elections.
Peter Hayes & Jeff Rosenberg
In our pre-election analysis, BlackRock offers suggestions as to where investors can find value in the current markets.
The investment environment has undergone massive changes in the past few decades, but the biggest impact is the radical increase in the availability of information for investment decision making. It's time for new investment processes and tools.
Mark Howard-Johnson & Sherry Rexroad
Mark Howard-Johnson and Sherry Rexroad recommend REITs for potential returns and dividend income, as well as a dose of diversification.
Chart of the Week
A diversified, tactically managed, multi-asset portfolio can result in better risk/return characteristics and improved inflation protection through various market cycles.
Michael Fredericks & Phil Green
Inflation can't be combatted in the rear-view mirror. Phil Green and Michael Fredericks recommend a multi-asset approach for incorporating inflation protection and long-term growth potential into a portfolio.
96%: Advisors who say their typical client has alternative investments in their portfolio
Learn about a new approach to portfolio construction and how "alternative" investments can play a larger role for individual investors.
Josh Tarnow, Portfolio Manager with the Leveraged Finance Portfolio Team, discusses opportunities for long/short strategies in the credit markets following the US election.
Josh Tarnow & Michael Phelps
With investors challenged to uncover fixed income solutions that provide return, diversification and stability, we spoke with BlackRock fixed income experts Josh Tarnow and Michael Phelps about the benefits of an allocation to fixed income credit.
Investment involves risks. Stock values fluctuate in price so the value of your investment can go down depending on market conditions. International investing involves additional risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. Long/short investing entails special risks. Short sales in securities that increase in value can cause a loss of principal. Any loss on short positions may or may not be offset by investing short sale proceeds in other investments. Long/short strategies present the possibility of significant or total losses, and that the long and short strategies may not perform, potentially adding to volatility and losses. Investing in derivatives entails specific risks relating to liquidity, leverage and credit that may reduce returns and/or increase volatility.
This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are those of the portfolio manager profiled as of April 24, 2013, and may change as subsequent conditions vary. Individual portfolio managers for BlackRock may have opinions and/or make investment decisions that may, in certain respects, not be consistent with the information contained in this report. The information and opinions contained in this material are derived from proprietary and non-proprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader.
You should consider the investment objectives, risks, charges and expenses of any fund carefully before investing. The funds' prospectuses and, if available, the summary prospectuses contain this and other information about the funds, and are available, along with information on other BlackRock funds by calling 800-882-0052. The prospectus and, if available, the summary prospectuses should be read carefully before investing.
The information on this web site is intended for U.S. residents only. The information provided does not constitute a solicitation of an offer to buy, or an offer to sell securities in any jurisdiction to any person to whom it is not lawful to make such an offer.
BLACKROCK, BLACKROCK SOLUTIONS, iSHARES and SO WHAT DO I DO WITH MY MONEY are registered and unregistered trademarks of BlackRock, Inc. or its subsidiaries in the United States and elsewhere. All other trademarks are those of their respective owners.
Prepared by BlackRock Investments, LLC, member FINRA.
Not FDIC Insured | May Lose Value | No Bank Guarantee
USR - 2043
Professor Chris Geczy
Learn about a new approach to portfolio construction and how alternative investments can play a larger role in a core investment strategy.