Reported by: banking|Updated: June 8, 2020
The markets have seen several crises including the most recent, global financial crisis back in 2008, the Asian financial crisis, dot-com burst, 9/11, the Harshad Mehta scam. However, this time seems much different and spine-tingling, as compared to what we have witnessed in the past. The pace of the fall has been breakneck at 3X of the pace we saw at the time of the global financial crisis, which was in itself 2X of anything we had seen previously.
Though a lot of indicators may suggest that two-thirds of the pain is over. Value at risk is at all-time historical lows, change in realized volatility is at all-time high, the gap between earnings yields and bond yield is currently lowest in the history, GDP as a percentage of market cap is almost at the lower end of the financial crisis. However, as I said, this time it seems different, so we cannot extrapolate history to call the market bottom.
We cannot time or control the market, but we can go back to the two most important fundamentals of portfolio construction and hedge the portfolio. First being asset allocation, which is a critical part of discipline investing. As much as 90% of the variability of returns and 100% of the absolute level of return can be explained by asset allocation.
Portfolios constituted of gold and debt have weathered this financial avalanche in a much more robust way. Portfolios which had exposure to dollar denominated assets will be able to counter the fall with the favorable moment in the currency. Even within the equity space, the fall across sectors has been much varied. Pharma which has been a laggard for the good part of the last decade has performed much better than the broader market, having fallen by less than half of the broader market. Consumer staples have fared well. Then there have been sectors like the PSU corporations which are trading at a low single-digit price to earnings multiples and in many cases less than 1 of price to book values, which could be a great addition to hedge the portfolios. Financials, on the other hand, have got the harder part of the stick, as the economic impact on them could be much worse if the coronavirus dictated lockdown continues for longer periods, resulting in higher NPA and permanent loss of capital for the financial institutions.
Cutting the long story short, a diversified equity portfolio across defensive sectors, value-driven opportunities and across stronger currencies can cushion the fall in these unprecedented and gory times. One also should diversify the portfolio with a bias towards large-cap companies as they tend to hold on to their value slightly better than the mid to small-cap companies.
Then there are more structured solutions to hedge the portfolio like the use of options. A long-only portfolio can be protected by buying a put option in the owned stocks. A put option gives you the right, but not the obligation to sell a share if the price move is favorable to the option holder. As your stock portfolio goes down, the value of the put option will go up and cover some of the losses you are experiencing in the stock portfolio. One can look at a put option as buying insurance for your portfolio. Think of this as buying fire insurance for your home. One can even offset the cost of buying a put option by selling a call option alongside. The selling of a call option covers part of the cost of the put option. The trade-off is that the upside will be capped. If the market rises above the call option strike price, the call option might result in losses. However, these will be offset by profits in the portfolio. This particular strategy is known as “collar”. There are similar strategies like covered call, put spread, etc. All these tools can be handy to hedge the portfolio especially in a bear market
On the overall asset allocation mix of equity, gold, debt, etc, one can also keep some exposure to hedge funds which hold both long and short positions and thereby end up generating positive returns even in a deep bear market.
Risk and uncertainty are two unavoidable sides of the market. Broader asset allocation, diversification across & even within each asset class and hedging a portfolio using structured solutions, can be some of the ways to protect the portfolio against a black swan event like the one we are currently facing and achieve one’s long term investment objective.
Amit Marwah, Chief Investment Officer, Dayim Holdings, Saudi Arabia