Friday, 23 August 2019
Written by Matthew Stuart-Box, COO, Head of Investment Platform
We have recently seen an increase in market volatility, especially in the US equity market with the Dow Jones Industrial Average falling over 3% twice this month (on the 5th and the 14th of August) and with market moves of over 1% seen on 8 trading days out to 10 so far this month (as of 14th August). This volatility has spread into other equity markets and currency markets with the Ringgit weakening to around 4.2 per USD.
The news headlines that triggered this volatility include the reduction in the Fed rate on July 31 as well as heightened worries over US/China trade friction following the announcement by President Trump on 5th August that he will designate China as a “currency manipulator” and concerns on the ongoing protests in Hong Kong.
In this blog, rather than focusing on the headlines, I will look at how MYTHEO portfolios tend to perform during market falls as well as some historical data on summer volatility and how investors should react to it.
MYTHEO portfolios and market falls
The investment models used by MYTHEO are based on the models developed for THEO in Japan which was launched in February 2016. There have been 5 months since then when equity markets have fallen by more than 5% (based on MSCI ACWI, the reference index for the Growth portfolio) so let’s look at how the THEO portfolios performed in these months.
If we compare the average return of the Growth portfolio and MSCI ACWI in these 5 months, we see that, although Growth return is negative, the size of the drawdown is more than 2% smaller than that of the reference index:
One reason for this is the approach that the Growth portfolio uses to construct the portfolio. The Growth portfolio mainly consists of equity ETFs which have relatively high volatility and high returns, but the portfolio is constructed to have the smallest possible volatility while remaining exposed to long term growth. This tends to result in smaller drawdowns in volatile months.
Of course, most THEO clients are invested in a blend of all 3 functional portfolios, but a similar effect can be seen when we look at the weighted average performance of THEO relative to the reference indices using an indicative allocation of 59% Growth, 30% Income and 11% Inflation Hedge:
The fall in the reference index is much less than that of MSCI ACWI due to the benefits of diversification across asset classes. Also, the fall in the THEO portfolio is much less than that of the reference index, due to the benefits of THEO’s portfolio construction approach.
The summer tends to be a bad period for equity markets with high volatility and poor returns. There has been a lot of academic research into why this may be the case but there are no firm conclusions, the most likely reason is that lower liquidity in the summer leads to larger reaction to negative news events.
To illustrate this, the table below shows the average returns of the DJIA each month from the period of 1950 to 2019. This clearly shows that returns in the period of May to September tend to be lower than in other months of the year.
However, when we look at returns over the next 3 months we see that, although returns tend to be negative in August and September, the return over the next 3 months to investors who buy during these months tends to be the highest. In other words, investors who buy during these weak months tend to be well rewarded over the following 3 months.
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This seasonality effect varies from year to year and should probably not be used as a way to try and “time the market”. However, it does show the benefit of diversifying your investments over time and in buying when the market is weak.
MYTHEO investors can gain from this seasonality effect through the “Omakase” investing approach since the monthly rebalance automatically tends to buy assets that have fallen in value and sell those that have risen. This ensures that the client is always at the target allocation and is fully positioned to benefit from any market recovery.
Investors can also benefit from seasonality by regular monthly contributions. Contributions in months where the market has fallen will be able to buy a larger number of shares (due to the lower price) and so will benefit when prices recover.
Market downturns are an inevitable part of investing and they are very difficult to predict. In this blog, I have shown how MYTHEO portfolios are built to be resilient to these downturns and how, through rebalancing and regular monthly contributions they can be turned to the investors advantage.