Weathering the Storm of Regime Changes: A New Approach to Navigating Time-Varying Risks in Equity Markets

The equity landscape is evolving rapidly, presenting today’s investors with unprecedented challenges. Short-term market cycles have made it increasingly difficult to capture long-term alpha, navigate sudden spikes in volatility, and preserve the integrity of portfolio diversification. This new frontier of investing requires a fresh approach to equity investing that can address time-varying risks, including heightened volatility, frequent drawdowns, and shifting cross-asset correlations. In this blog post, we’ll summarize the key points of our in-depth paper and discuss an innovative solution for equity investors in today’s complex market environment.

Time-Varying Risks

VOLATILITY
Market volatility has increased, with economic cycles, geopolitical uncertainty, algorithmic trading, and market sentiment contributing to this phenomenon. Increasing and time-varying volatility has significant implications for investors, as it can erode returns, increase the likelihood of drawdowns, and complicate the task of portfolio diversification. To navigate this challenge, investors must adopt strategies that effectively manage volatility while capturing alpha.

DRAWDOWNS
Drawdowns have become more frequent and severe in recent years. The magnitude, frequency, and duration of these phenomena require investors to be prepared and develop strategies to manage and mitigate drawdown risk. A well-designed portfolio should be able to weather drawdowns without compromising its long-term performance.

CROSS-ASSET CORRELATIONS
Shifting correlations between asset classes can undermine portfolio diversification objectives, making it challenging for investors to construct portfolios that can withstand market fluctuations. By understanding how correlations change over time and incorporating this knowledge into their investment strategies, investors can better manage risk and improve portfolio resilience.

Revolutionary Solution: Alpha with Resiliency

To address these time-varying risks, we propose an innovative approach to equity investing that systematically adjusts exposures in response to both short- and long-term risk cycles while offering convexity to hedge tail-risk events. This solution involves synthesizing managed futures into equity strategies, creating a versatile, all-season portfolio that can potentially deliver better diversification, risk reduction, and improved risk-adjusted returns.

By allocating 5% of the cash in an equity strategy to collateralize a multi-asset, exchange-traded futures strategy, investors can create a new framework for time-varying risk management. This combination provides the necessary flexibility to respond to market changes while retaining the performance characteristics of a typical large-cap core equity strategy.

Access Convexity

The relationship between equities and managed futures is convex, meaning that as one asset class experiences losses, the other may experience gains. This non-linear relationship offers several potential benefits for investors, including better diversification, greater risk reduction, and improved risk-adjusted returns. By integrating managed futures and equities, investors can increase diversification within and across asset classes, reduce equity and overall portfolio risk, and potentially enhance returns.

Integration, Not Overlays

Instead of integrating equity and managed futures strategies, some investors might consider a managed futures overlay. However, we argue that an integrated approach is more practical and offers several advantages:

• Capital Efficiency: Integrating managed futures within an equity strategy allows for more efficient use of capital and margin requirements.
• Performance Efficiency: An integrated approach can be more responsive to changes in market conditions, maximizing potential benefits.
• Cost Efficiency: Managing both portfolio components within the same structure can reduce trading costs and simplify the investment process.
• Governance Cost: Particularly relevant for pension funds, integrating strategies can lead to lower governance costs compared to overlays, as it streamlines the decision-making process and reduces the need for additional oversight.

Modernize Your Equity Strategies

Equity investors face an increasingly unpredictable market environment characterized by relentless regime changes. Traditional risk management tools often fail to address these complexities without negatively impacting alpha. As a result, investors must look towards innovative approaches that can adapt to the evolving landscape.

Our in-depth paper presents a compelling case for integrating managed futures into equity strategies, creating a versatile, all-season portfolio that systematically adjusts to both short- and long-term risk cycles. This integration not only offers better diversification, risk reduction, and improved risk-adjusted returns but also proves to be more capital-efficient, performance-efficient, and cost-effective than a managed futures overlay.

In this era of market uncertainty, it is crucial for investors to adopt forward-thinking strategies that address the challenges of today’s markets while maintaining the potential for long-term success. By embracing the integration of managed futures in equity strategies, investors are better positioned to navigate the complexities of the modern financial landscape and achieve their investment objectives.

We believe the time has come to modernize your equity strategies, revolutionize your approach, and prepare your portfolio for the challenges that lie ahead. By understanding and addressing time-varying risks and adopting an innovative approach that integrates managed futures into equity strategies, investors can build resilient portfolios designed to thrive in the face of market turbulence and uncertainty.

Download the Full Paper

Equip yourself with the knowledge and tools necessary to navigate the complexities of the modern financial landscape and achieve your investment objectives. Download the paper now and learn how to transform your equities for the road ahead.

This material is for general informational purposes only and should not be construed as investment advice, as an offer or solicitation of an offer to sell or buy, or as an endorsement, recommendation, or sponsorship of any company, security, advisory service, or fund nor does it purport to address the financial objectives or specific investment needs of any individual reader, investor, or organization. This material should not be used as the sole basis for investment decisions. The appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives.

Nothing in this material shall be deemed to be a direct or indirect provision of investment management services specific to any client requirements. There are numerous other factors related to the markets in general that should be considered before making any investment decision. All content is presented by the date(s) published or indicated only and may be superseded by subsequent market events or other reasons. No forecasts can be guaranteed and there is no guarantee that the information supplied is complete or timely, nor are there any warranties with regard to the results obtained from its use. Intech is the source of data unless otherwise indicated and has reasonable belief to rely on information and data sourced from third parties.

Past performance does not guarantee future results. Investing involves risk, including the possible loss of principal and fluctuation of value. The value of an investment may go down as well as up and you may not get back what you originally invested. Nothing herein is intended to or should be construed as advice. 

Futures are speculative, highly leveraged, and involve a high degree of risk. Volatility increases risk, particularly when trading with leverage. Futures and forward positions cannot always be liquidated at the desired price. Investments can be subject to low liquidity, meaning there may not be a seller or buyer available when the investor desires to invest or divest.

An index is unmanaged, is not available for direct investment, and does not reflect the deduction of management fees or other expenses.

MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This material has not been approved, reviewed, or produced by MSCI.

In Australia, this information is issued by Intech Investment Management LLC (Intech) and is intended solely for the use of a wholesale clients as defined in section 761G of the Corporations Act 2001 (Cth) and is not for general public distribution. Intech is permitted to provide certain financial services to wholesale clients pursuant to an exemption from the need to hold an Australian financial services licence under the Corporations Act 2001. Intech is regulated by the United States Securities & Exchange Commission (SEC) under U.S. laws, which differ from Australian laws. By receiving this information, you represent that you are a wholesale client.

Intech is not permitted to offer products and services in all countries and not all products or services are available in all jurisdictions. This material or information contained in it may be restricted by law, may not be reproduced or referred to without express written permission or used in any jurisdiction or circumstance in which its use would be unlawful. Intech is not responsible for any unlawful distribution of this material to any third parties, in whole or in part. The contents of this material have not been approved or endorsed by any regulatory agency.

Material Risk and Limitations

Information containing any historical information, data, or analysis should not be taken as an indication or guarantee of any future performance, analysis, forecast, or prediction. More recent simulated performance results may be lower or higher than the performance results shown. Before investing in any investment strategy, please carefully consider the investment objectives, risks, fees, charges, and expenses.

Any portfolio risk management process discussed that includes an effort to monitor and manage risk, should not be confused with and does not imply low risk or the ability to control risk. No investment process can eliminate the possibility of negative random events driving performance for short periods. There is no guarantee that any investment strategy will achieve its objectives, generate profits, or avoid losses.

Investors should note that tax treatment in relation to any investment will depend on your individual circumstances and may be subject to change in the future. Intech does not provide any regulatory, tax or legal advice.

The following section provides investors with an overview of the key material risks and limitations that you should take into account when deciding whether to invest. It does not explain all of the risks involved or how the risks relate to each investor’s circumstances. Multiple factors contribute to investment risk for all investment strategies and additional factors contribute to investment risk for specific strategies. The risks listed below are not intended to be a complete description or enumeration of all the associated risks with the strategy. There are numerous risk factors related to the market in general or to the implementation of any investment strategy, all of which should be carefully considered before investing.

Risk of Loss – There are inherent risks associated with investing in securities markets. Investing in securities involves risk of loss that investors should be prepared to bear. The risks will vary based on the nature and attributes of the relevant investment strategy and the specific securities and other instruments held. The characteristics of the strategy described in this presentation are sought during the portfolio management process. Actual experience may not reflect all these characteristics or may be outside of stated ranges. The strategy described in this presentation is speculative, involves substantial risk, and is not suitable for all investors. There is no performance guarantee associated with investing in any Intech strategy. There can be no assurance that the objectives associated with any Intech strategy will be met or that any investor will or is likely to achieve the investment results described in this presentation. Past performance is not necessarily indicative of future results.

Intech’s products are designed for long-term investors interested in a portfolio of equity securities. By concentrating in equity investments, the main risk is that a portfolio will be subject to the risks of the equity markets. The value of investments in equity securities may experience sudden, unpredictable drops in value or long periods of decline in response to many factors including those arising from general economic conditions, historical and prospective earnings of an issuer, government regulations, political events, investor sentiment, market liquidity, and other social issues. The value of a portfolio could also decrease if the stock market goes down, regardless of how well some individual companies in the portfolio perform.

Volatility Risk – The market prices of a portfolio’s investments can be highly volatile. Price movements of assets are influenced by, among other things, interest rates, general economic conditions, the condition of the financial markets, developments or trends in any particular industry, the financial condition of the issuers of such assets, changing supply and demand relationships, programs and policies of governments, and national and international political and economic events and policies.

Active Equity Strategy Risk – If Intech’s method of identifying securities with higher relative volatility versus the named benchmark or its method of identifying securities that tend to move differently relative to each other (low correlation) does not result in selecting securities with continuing relative volatility or the expected correlation, a portfolio may not outperform the benchmark index. Further, as a result of the investment process, portfolios tend to overweight smaller capitalization members of the benchmark index, which typically exhibit greater volatility, primarily because of the potential diversification gains due to the lower correlations of their performance to that of the larger capitalization members of the benchmark index. Consequently, in conditions where larger capitalization members are outperforming the benchmark index, and fewer stocks are driving benchmark index returns, the strategy may underperform relative to the benchmark.

In addition, this strategy includes investments in futures and forwards markets, are speculative, highly leveraged, and involve a high degree of risk. Volatility increases risk, particularly when trading with leverage. Futures and forward positions cannot always be liquidated at the desired price. Investments can be subject to low liquidity, meaning there may not be a seller or buyer available when the investor desires to invest or divest.

Developed Countries Risk – Investments in developed countries subject a portfolio to regulatory, political, currency, security, demographic, and economic risk specific to developed countries. Developed countries are impacted by changes to the economic health of certain key trading partners, regulatory burdens, debt burdens, and the price or availability of certain commodities. Developed countries tend to represent a significant portion of the global economy and have generally experienced slower economic growth than some other countries or regions.

Global and Emerging Markets Risk − Investments in global markets have additional risks. Global securities tend to be volatile and may involve greater risks, including currency risk, adverse political or economic developments in certain countries, the relative lack of information, relatively low market liquidity and the potential lack of strict financial and accounting controls and standards. These risks are magnified in emerging markets. The prices of global securities held in a portfolio may decline in response to such risks.

Industry and Sector Risk − Although the strategy will not typically concentrate its investments in specific industries or industry sectors, at times, it may have a significant portion of its assets invested in securities of companies conducting similar business, or business within the same economic sector. Companies in the same industry or economic sector may be similarly affected by economic or market events, making a portfolio more vulnerable to unfavorable developments than portfolios that invest more broadly. As a portfolio becomes more concentrated, it is less able to spread risk and potentially reduce the risk of loss and volatility. In addition, a portfolio may be overweight or underweight in certain industries or sectors relative to its benchmark index, which may cause the portfolio’s performance to be more or less sensitive to developments affecting those sectors.

Diversification Risk – Diversification of holdings does not protect against market risk and does not ensure a profit or guarantee against a loss.

Proprietary Investment Process and Trading Methods Risk – An investor will not be able to determine all the details of the proprietary nature of our investment processes and trading methodologies.