Market timing and big calls: What happens when they’re wrong?

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By Michael Armitage | 05 July 2017

Big market timing calls can make or break reputations–and businesses. Few get it right, but that doesn’t stop many from trying.

Whenever market valuations seem to be getting stretched, various active managers will make market timing calls. More recently, Altair Asset Management returned all its Australian equity funds to investors and RBS warned investors to “sell everything” in early 2016, while prominent investors including Stan Druckenmiller, Carl Icahn, George Soros and Bill Gross have built their reputations with significant market calls.

It’s a commendable decision whenever active investors, particularly those with skin in the game, put integrity ahead of short-term fee income.

If their predictions prove right and the market suffers a major correction, they’ve potentially made a significant name for themselves and will enjoy fund inflows. However, if the market continues to march higher over the coming years, their reputations may suffer.

While markets have certainly run hard to date, many investors are still predicting that the valuation of global asset prices can remain at current levels or travel higher.

Does this mean they lack integrity? Hardly. No, that’s what makes a market.

Almost a decade on from the global financial crisis, many developed economies remain at an unusual juncture. Despite an uneven pickup in global growth, markets are still being underpinned by a wall of central bank money.

The US Federal Reserve’s quantitative easing program ended in December 2014 but, since then, the central banks of Europe, Japan, Switzerland and England have grown their balance sheets by 65% in aggregate.

In 2017, they have added a further US$1 trillion in assets bringing their total debt to US$10.3 trillion–it shows just how far the world has to go to revert to “normal”.

Figure 1

Source: Milliman FRM Insight April 2017 Market Commentary

The impact that the end of central bank support will have on markets is impossible to predict as is the impact of rising geopolitical risks around the world. Markets have ups and downs, but history shows timing those changes isn’t consistently possible-however much sense they make in hindsight.

Investors who acknowledge the difficulty of timing markets or super funds that are constrained from making such sweeping market calls and de-allocating from equity markets need to consider other options to manage risk.

A dynamic exposure management strategy utilising exchange-traded equity index futures is one low-cost risk management strategy that has proven to be effective.

Hedge assets can act independently of an underlying portfolio, allowing investors to retain exposure to the bulk of the market’s upside while softening the impact of volatility and market corrections when necessary.

These types of strategies allow investors to continue to reap returns while markets remain strong–unlike those who get their market timing calls wrong.

Recently, most developed equity markets have continued to perform strongly, reaching new “all-time highs” while volatility has been particularly subdued. The three-month volatility of the S&P Global 1200 Index touched a new 10-year low in April 2017.

In this environment, managed risk strategies have generally employed their maximum equity allocations and enjoyed strong returns. But at the same time, these “always on” rules-based approaches have been monitoring and analysing volatility and capital preservation positions standing ready to adjust exposure to risk as markets dynamics determine.

Over the long term, managed risk strategies have shown their worth.

The S&P 500 Managed Risk Index has delivered an average annualised return 1.09% above a 70:30 blend over the 10 years ended April 2017. During that time, its volatility was 200 basis points lower than the 70:30 blend with half the maximum drawdown.

Figure 2

Source: Milliman FRM Insight April 2017 Market Commentary

However, after so many years of market gains, many investors have become complacent about risk while others have started making big calls about the end of the market cycle.

Only time will tell who is correct in both the near term and long term. A managed risk strategy is a prudent middle-ground approach that can manage the potential downside while still allowing investors to participate in the bulk of the market’s upside.

Disclaimer

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