Harindra de Silva, Portfolio Manager and Co-Head of Systematic Research, discusses the impact of volatility on the markets and what the risks and opportunities are in this current environment.

 

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Brian Neuman: I’m Brian Neuman, and you’re listening to On the Trading Desk®.

There is no denying that we are experiencing volatility across many areas of life, whether it’s geopolitical and, of course, market and economic, just to name a few.

Joining us today to discuss this volatility and its impact on the markets, we have Harin de Silva, portfolio manager and co-head of Systematic Research. Harin, thanks for being here.

Harin de Silva: Nice to be here, Brian. Thanks for having me.

Brian: So jumping straight in, when you think about our current backdrop of inflation, supply chain issues, of course, lingering COVID-19, and on top of it, a conflict in Ukraine, from a historical perspective, have we seen markets like these before?

Harin: We have not actually seen the confluence of these three types of events before.

And I’ve gone back and looked at history. We have 150 years of great economic and stock market data, especially in the U.S. and in European markets, and there is no other time period where you’ve seen these two external shocks. In this case, a pandemic, as well as a potential nuclear war breaking out, combined with the end of an economic recovery and accelerating inflation.

And so it’s hard to use history as a guide as to what we should do here.

Brian: So with that said, you’ve long been at the forefront of research and thinking about volatility and its relationship to investing. It would be great to hear a bit more about the opportunities or risks that you are observing in our current environment.

Harin: Yes, so I would break it down into two types of risk.

One is the economic risk associated with inflation slowing growth, things that we are seeing worldwide as central banks try to manage inflation. That usually results in higher business cycle volatility. So that’s something that we’ve seen before.

We know how to manage this. You can manage it by holding a little more risk-free assets in the portfolio. We certainly don’t want to hold fixed income in a portfolio in a time of rising rates. So that’s our guidebook or cookbook on how to deal with that.

The thing that we don’t have a lot of experience with is managing tail risk, like you do with the situation in Ukraine or what’s going on with the ongoing pandemic, especially if you look at what’s going on in China.

So from my perspective, the two things you need to think about is how diversified is your portfolio from a tail risk perspective. And what I mean by tail risk was if the situation with the war gets worse, if the situation with the pandemic rears its head again, do you have assets that are actually going to be appreciating or less sensitive to those events?

So minimizing the beta of your equity portfolio, making sure you have securities that are more local as opposed to more global—so, for example, having a small-cap tilt—those are things that could really, really help your portfolio from a diversification perspective given the risk that we’re facing in the next three to five years.

Brian: Thanks, Harin. As a natural extension to that prior question, I know so many of our clients and prospects are thinking about this volatility and thinking about ways to manage that volatility.

And so at Allspring Global Investments, what tools do we have to help our clients navigate this market environment?

Harin: So there’s actually two sets of tools we use.

One is using option-based strategies. Option-based strategies are a great way to hedge tail risk. So you can use a combination of buying puts or using put spreads to cheapen the cost of puts, and we’ve seen a lot of interest in using this type of strategy from both institutions, as well as large individual accounts. So that’s something that we really encourage people to think about as a way or a technique that can be used to ride through this volatility storm that we may be facing.

You can also use things like covered call strategies, which actively managed, allow you to control the market exposure of your portfolio, but at the same time, generate income, which can provide cushion in a falling market or a flat market.

So both those strategies are run by our options team, and we’ve been actively engaged in various clients in a very active dialogue on how they might use those types of strategies to enhance their portfolios.

The other technique that we’ve used very successfully in the past is using short positions. Some of our strategies, which are available in separate accounts as well as mutual funds, do actively use shorting as a tool to manage the risk of the portfolio.

And this way, you have a return that’s basically not highly correlated with the market, in fact, negatively correlated with the market, so when you add it to a portfolio, you really reduce the overall risk of your portfolio.

So both those techniques, using options as well as using long-short strategies, I’ve seen a lot of interest in in the last three months as people have become aware of the fact that the risks they’re facing now are very different than the risk that we’ve face in the last 10 to 20 years. In the last 20 to 30 years, basically big-cap tech dominated. And that single bet, if you had exposure to big-cap tech, your portfolio did really, really well and you really didn’t have much to worry about from a hedging perspective.

Brian: Yeah, it’s really interesting to think about. So under this backdrop of what we talked about—the volatility, both geopolitically and, of course, market-driven—if you had a last thought you’d like to leave our listeners with, what might it be?

Harin: I would say the most important thing right now is to recognize your biases. And as individuals, we have a very strong recency bias, right? We weigh what happened recently too much.

And when I think about the last 10 years, yeah, we’ve seen some difficult markets, but we’ve always seen a very quick bounce back. So the tendency to believe that buying dips always works, that big-cap tech always works, that indexing always works, I think the way we view the world is really clouded by that recency.

And I would encourage people, as they think about their portfolio, don’t ask yourself how would it have done in the last three years to five years, but ask yourself how would this portfolio have behaved in the early 70s when we had all the shocks from the Middle East? How would it have behaved during the Cuban missile crisis?

So think about those types of scenarios and make sure that if that event does occur that you’re not surprised in a really negative way.

Brian: That’s really insightful. Harin, thanks for being with us today.

Harin: Thanks for having me, Brian.

Brian: That wraps up this episode of On the Trading Desk.

If you’d like to read more market insights and investment perspectives from Allspring Global Investments, you can find them at our firm’s website, allspringglobal.com.

To stay connected to On the Trading Desk and listen to past and future episodes of the program, you can subscribe to the podcast on Apple Podcasts, Spotify, Google Podcasts, or whatever podcast subscription service you use. Until next time, I’m Brian Neuman; stay invested.

 

Disclosure: All investing involves risk, including the possible loss of principal. There can be no assurance that any investment strategy will be successful. Investments fluctuate with changes in market and economic conditions and in different environments due to numerous factors, some of which may be unpredictable. Each asset class has its own risk and return characteristics.

Beta measures fund volatility relative to general market movements. It is a standardized measure of systematic risk in comparison with a specified index. The benchmark beta is 1.00 by definition. Beta is based on historical performance and does not represent future results. Diversification does not ensure or guarantee better performance and cannot eliminate the risk of investment losses. An equity option is a contract that gives the purchaser the right, but not the obligation, to buy or sell a stock at a specific price within a certain period. There are numerous risks associated with transactions in options on securities and/or indices. As a writer of covered call options, the portfolio forgoes the opportunity to profit from increases in the values of securities held by the portfolio. However, the portfolio has retained the risk of loss (net of premiums received), should the price of the portfolio’s securities decline. Similar risks are involved with writing call options or secured put options on individual securities and/or indices held in the portfolio. This combination of potentially limited appreciation and potentially unlimited depreciation over time may lead to a decline in the value of the portfolio.

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