(March 9, 2012) — How can investors make more important decisions for portfolio construction if they are aware of falling correlations across some important asset classes and risk factors?
The answer, according to Vineer Bhansali of Pacific Investment Management Co. (PIMCO), comes in four parts:
1) Pay attention to the signals sent by policymakers. “The gentle opponents of the market participant today are central banks, policymakers and regulators. Their cues, such as liquidity provisions, selection of particular entities (nations and banks) as survivors or failures, are important cues on where the ball will go,” according to PIMCO.
2) Continue to focus on relative value. If correlations continue to fall, participants will likely gravitate towards alpha opportunities.
3) Hedge Tails. “Given the low levels of volatility and implied correlations, it has become much less expensive to hedge the fat left tails using systemic hedges.”
4) Diversify. The paper notes that in order to do diversification properly one needs to focus on the underlying risk factors, not simply on the assets.
According to PIMCO, the availability of high-frequency information, technological advances in electronic trading, along with the dominance of government and regulatory policy factors has made the world since the crisis of 2008 a risk-on/risk-off environment. Thus, Bhansali asserts that investors can better respond to the market by paying greater attention to “anticipatory cues” to guide portfolio contraction.
Comparing a tennis player to an investor, Bhansali states:
“Via many years of practice, a pro learns how to ‘read’ the slightest variations in foot placement, ball toss – even head movement – to position and start to react in advance of the actual serve. Paying attention to peripheral indications and patterns of behavior of an opponent is a well-tested way to improve reaction time and get ahead of the actual event.”
PIMCO’s description of a “risk-on/risk-off” environment — in which high correlations between asset classes are seen at times of market turmoil — follows a Bank of America Merrill Lynch Fund Manager survey that showed institutional investors regained more confidence in the global economy in January than in the last 30 months, and are actually ready to take on more investment risk.
According to the Bank of America Merrill Lynch Composite Risk and Liquidity Indicator was the highest since July last year. Michael Hartnett, Chief Global Equity Strategist at Bank of America Merrill Lynch Global Research, said: “Investors are tip-toeing rather than hurtling toward higher risk exposure; the US market and high quality cyclical sectors, such as energy and tech, have been the main beneficiaries of lower cash holdings.”
Earlier this year, MFS Chief Investment Strategist James Swanson told aiCIO that technology stocks were some of his main picks for outperformance in 2012.
The proportion of investors taking lower than normal levels of risk, according to the recent study by Bank of America Merrill Lynch, has improved to a net 33% of the panel, compared to a net 42% in December.
However, the survey said that investors had become more concerned about geopolitical risk than a month earlier. It said the proportion of respondents viewing geopolitical risk as “above normal” had jumped to 69% from 48% in December.