In periods of market stress some protected funds retreat from equities into cash; however, Ari Towli, a portfolio manager at Smart Investment Management Limited (Smartim), says this might not provide the best outcome for investors. He asserts that strategies which use tactical asset allocation can better navigate varying market conditions without permanently locking in losses, as happens with certain CPPI (constant protection portfolio insurance) strategies.
The return of volatility is fuelling debate about when the equities bull market will end. The US economy has been boosted by tax reforms which have extended the equities rally; however, the strengthening dollar has adversely impacted emerging markets that fund themselves in US dollars, as they have seen the cost of servicing their debt increase. Investors are looking for a catalyst to bring this cycle to an end, but the only possibility seems to be from political sources such as the US midterm elections in November and an all-out trade war with China. Historically, market cycles have ended mainly due to late-cycle policy error from monetary authorities, so a close eye must be kept on the Federal Reserve's stance on further monetary tightening.
Towli, who has over 19 years’ experience in multi-asset and multi-manager investing and has been a manager on Smartim’s Smartfund 80% Protected funds since their launch in September 2015, believes markets have entered “mid to late cycle” with an increasing chance of recession. Recessions generally occur every 10 years, and with the last recession taking place in 2008 it’s possible that the economy could slip into recession at any time. That said, he believes the signs indicate that the current market cycle will continue into next year and perhaps beyond.
In these conditions Towli says that having the right protected strategy can allow investors to remain invested in equity markets, but at the same time have the assurance that their capital is protected from major losses. Unlike a normal CPPI the Smartfund 80% Protected fund is not forced to sell risky assets during falling markets and will not “cash lock” investments should the portfolio value reach the protection level; this will allow the investment to benefit as markets recover whilst adopting a sensible tactical asset allocation strategy to help smooth returns. “CPPI strategies tend to de-risk in times of market volatility, converting into low-risk bond portfolios, so when markets bounce investors are left disappointed because they haven’t had the opportunity to participate in the upside.”
One example of tactical asset allocation in practice took place during Brexit. Towli says Smartim’s base-case scenario was that the UK would remain in Europe; however, as polls suggested the result was becoming increasingly hard to call, the team decided to reduce the exposure to sterling in favour of the US dollar to cushion the effect of a potential sharp fall in sterling should the ‘leave’ vote prevail. “Obviously this did materialise. Our overseas exposure meant that we protected the portfolio, which was a good outcome for our investors,” he says.