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Politics Cranks Up The Volume On Volatility

All bets are off this election season Last week, the long and rancorous 2016 GOP presidential primary season came to an abrupt end as two of the three remaining candidates dropped out of the race. In a development that has astounded political pundits, Donald Trump is now the presumptive Republican nominee for President of the United States. Ironically, Hillary Clinton – who has long been viewed as the likely Democratic nominee – is still ensconced in primary season, slugging it out with her resilient challenger, Bernie Sanders. It remains to be seen whether Clinton can win key states such as California and finally capture the nomination. And every day that she must fight within her party weakens her, as she is being criticized from both the left and the right, which negatively impacts her ability to win in the general election. It seems that nothing thus far in this race has been going according to plan. Early on, pundits had predicted Donald Trump had no chance of winning the nomination, dismissing his bid as quixotic; similarly, they minimized the potential appeal that a candidate such as Bernie Sanders could engender and predicted an easy primary season for Hillary Clinton. Both assumptions have obviously been proven wrong. And although all Republican candidates for president signed an agreement that they would support the nominee, some are now reneging on the pledge. For his part, Trump has warned that his supporters may riot at the Republican National Convention this July if he does not get the nomination, although that now seems moot given all challengers for the nomination have fallen away. Meanwhile, candidate Sanders has suggested he will remain a candidate through the end of primary season and force a contested convention. What’s more, some prominent Republicans are already announcing they will not support Trump as their nominee in his bid for president. When House Speaker Paul Ryan announced last week that he is “just not ready” to endorse Trump, former vice presidential candidate Sarah Palin said she would campaign to unseat Ryan in the primary. And there are questions about whether, if Clinton is able to secure the Democratic nomination, Sanders supporters would stay home rather than vote for her in the general election. All bets seem to be off this election season, with some conservative Republicans even calling for a third-party candidate. Politics outside the proverbial box Adding to the disorder is that candidate Trump has a controversial platform that is not traditionally Republican in some important regards. For example, Trump’s suggestion last week that the US could renegotiate bond obligations to pay less than face value on US Treasuries to its debt holders, as Greece has done, could roil capital markets. In addition, Trump’s protectionist stance is of concern to many businesspeople because they fear a curtailment of free trade. Another area of concern is the US income tax code. Earlier this week, Donald Trump said he was open to raising taxes on the wealthiest Americans, a reversal of his original platform of decreasing taxes for those in all income tax brackets. This new position flies in the face of a key tenet of the Republican Party for two decades – and makes it more difficult to differentiate him from Democratic candidates. Perhaps even more controversial than Trump’s stance on certain issues is that of candidate Sanders, whose platform includes a protectionist approach to trade and a dramatic increase in income taxes on higher-income Americans. It seems that the candidates with the most fervent supporters are the ones whose platforms exist outside the proverbial box of their respective parties, which makes sense given American’s growing distrust of the “establishment.” Stock market uncertainty Pundits, of course, are saying that 1) Trump’s campaign platform will become more moderate now that he has to appeal to the general populace; and 2) it doesn’t matter anyway because he has a snowball’s chance in hell of winning the election in November. While the former may be true, any material changes in platform create uncertainty and ultimately reduce credibility – which is not typically met with approval by the stock market. But more importantly, the pundits have been terribly wrong about the candidacy of Donald Trump since the start, which suggests they could continue to be terribly wrong. After all, some of Donald Trump’s positions – such as maintaining Social Security at its current level – are likely to be more appealing to the general populace than to fiscally conservative Republicans. In other words, Trump may prove more popular in the general election than many expect – perhaps more popular than he has been in Republican primaries. Some even go so far as to argue that there is a significant cohort of dissatisfied voters that could support either Trump or Sanders. What’s more, if Clinton were to become the Democratic nominee, she may have difficulty winning over many Republican voters reluctant to support Trump, particularly given that she continues to be tugged to the left by the powerful primary challenge from Sanders. A pivot to the center, if and when she has secured the nomination, could similarly suffer from a lack of credibility, causing voters to wonder what they will actually get come January. Volatility up ahead This commentary is not intended to be an endorsement or indictment of any of the presidential candidates. What we’re concerned with is the stock market’s reaction to this year’s ongoing election developments. For example, a surge in the polls for Hillary Clinton could result in a sell-off of the healthcare sector on the assumption, rightly or wrongly, that her administration would have a negative impact on the health care industry. It’s no surprise, then, that some financial advisors I talk with are becoming increasingly worried about the presidential election and the potential for a substantial sell-off. In this “all bets are off” election, investors need to be prepared to be surprised – which means to be prepared for more volatility. Given not just this election but a potential Brexit, growing discontent in Europe and ongoing problems in the Middle East, it seems political developments around the globe could be the biggest source of volatility for investors this year. In this environment, investors will be well served by being tactical asset and sector allocators – and by focusing on downside protection in their respective portfolios.

Take The Long-Term View To Manage Volatility

By Tom Lee, Managing Director, Investment Strategy and Research, Parametric Volatility today is not materially above the long-term average. If we use the CBOE Volatility Index as a reference, volatility since the end of 2015 averaged a little over 21 ½. Long-term VIX averages in the high 19s. The reality is people think we are in a higher-volatility environment because we came from, historically, a relatively low-volatility environment. Volatility tends to cluster into regimes. The volatility environment we’re in now is more normal. What caused volatility to elevate? There are a lot of contributors to volatility. There are the experimental and divergent monetary policies that are being pursued across the globe, including negative interest rates. And there’s also an intuitive understanding that the longer we are in this experimental monetary policy phase, the higher the risk is of some unintended consequence. We’re going to have this uncertainty for a while. Asset allocation Having said that, I don’t think that volatility should drive changes in asset allocation. Volatility tends to cluster in regimes and it would be very hard for an investor to time an upward or downward move. I think investors should structure their portfolios for the long term. I would say that now is a very prudent time for investors to closely observe their portfolio and make sure they have transparency into all the risks they’re taking and address unintended risks. As an example, recently investors have become very interested in hedging their currency exposure – after the strong rally in the dollar. They’re hedging only after they’ve experienced the risk. We are advocates of investors trying to get ahead of the curve with respect to risk. Investors need to show fortitude as volatility picks up and not overreact to events in the market. Staying the course What can investment managers do? First and foremost, investment managers can come up with ways that help the client to stick to their policy portfolio. So, as an example, they can offer seamless rebalancing methodologies. Investment managers can be more transparent about their strategies. By this I mean every strategy has periods when the wind is at its back and periods where you’re running into the wind. Overall it’s helpful to be more transparent about what environments will be challenging for a strategy. And if managers are forthright with the client about this, it’s less likely the client is going to terminate them during a challenging period. Frequently, in hindsight, we see that these challenging periods were absolutely the wrong time to terminate a strategy. Low-volatility strategies Low-volatility strategies are always worthy of consideration but investors need to be conscious of what they’re getting into. Most strategies are constructed around two general themes, a risk metric construction process and a min-variance process. Risk metric just involves sorting the index by various volatility metrics. Minimum variance looks beyond risk metrics and incorporates correlations among securities. All low-volatility factor construction uses some type of concentration limits. You need to understand that these strategies don’t outperform in every situation, namely a down market. For example, the S&P 500 Low [Volatility] Index has underperformed the S&P approximately 15% of the time when the market was negative. So investors have to understand that they can have these downward surprises. If investors want to avoid these types of surprises, either asset allocation or diversification through the introduction of other risk premiums will provide them with greater certainty of low volatility when they most want it, and that’s in a negative market environment. Holding cash In regard to holding cash, I think it’s challenging for an investor in the long term. They are holding risk assets to fund future liabilities, which are growing faster than cash. Investors holding cash also struggle to realize when the market is bottoming so they can time their move out of cash into risk assets. If you are really thinking about holding cash as a modest form of protection, there are other strategies available. A very simple one is a disciplined covered-call selling program that will generate cash in a stressful environment and dampen some of the downside volatility. That, to us, would be more prudent than parking money in cash. Derivatives Derivatives can and have been used to control portfolio volatility. Historically investors have used long puts or put spreads to control downside risk in portfolios. I am generally not an advocate of this approach. It needs to be highly customized to the particular investor and it can lead to a lot of challenging decisions. How do you pay for the downside protection? Do you sell away upside? Experience shows that most investors become fatigued with the expense and tend to terminate programs, often right before a market experiences challenges. Options An alternative approach is to sell fully collateralized options. This approach seeks to capture the volatility risk premium, which is embedded in options. It often makes more sense to de-risk the portfolio and consider being a seller, rather than a buyer of the hedge. The first adopters of this type of strategy were endowments and foundations. More recently there is increased interest from Taft-Hartley funds that are dealing with particular pension funds and mark-to-market issues, as well as public fund investors. There are benefits of selling volatility in a transparent, liquid and fully collateralized manner. One preferred way of doing that is through index options and trying to capture what academic and market research has identified as the volatility risk premium. The result is that this premium can be captured in a transparent, liquid manner and it shows diversification benefits versus traditional assets. It can have a material and positive impact on a portfolio over time. Focus on the long term Many investors look at volatility and are fearful. They intuitively understand that rising volatility generally means more stressful market environments. Investors need to take a step back and focus on the long term, and not become reactionary or fall into short-term pitfalls and try to shuffle their portfolio to follow some latest fad. As markets evolve there may be better approaches available to them that allow them to achieve their ultimate objectives. So be open to new ideas. There’s a lot of really creative thought going on right now in different areas that maybe in a couple years will become more mainstream. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.