December 15, 2022 | 9 Minute Read
CFA, EMEA Head of Portfolio Strategy, Strategic Advisory Solutions
Global Head of Strategic Advisory Solutions
Geopolitical tensions, hot inflation prints, global central bank tightening, and higher interest rates have driven market volatility higher. To put the extraordinary volatility we have lived through in perspective, in 2022:1
Though markets may find some relief in a potential peak both in inflation and in central bank hawkishness next year, we expect overall volatility to remain elevated and prone to sudden spikes in 2023 and beyond, as the tailwinds that helped lift markets during the last market cycle have dissipated. For context, the pre-pandemic cycle experienced very strong growth, falling interest rates, rising profit margins, and low starting valuations. Today, the post-pandemic cycle features decelerating growth, rising interest rates, stable profit margins, and high starting valuations. This reversal of tailwinds suggests to us that volatility, once episodic, has turned endemic.
As such, our assumptions over the next 10 years assume higher expected volatility for both traditional and satellite asset classes.
Source: SAS Portfolio Strategy/Goldman Sachs Asset Management. Historical risk characteristics (2011-2021) are based on the representative indices’ performance and does not represent performance for any Goldman Sachs product. Alpha and tracking error assumptions reflect Multi-Asset Solutions’ estimates for above-average active managers and are based on a historical study of the net-of-fee results of active management. Strategic long-term assumptions are subject to high levels of uncertainty regarding future economic and market factors that may affect future performance. They are hypothetical indications of a broad range of possible returns. All numbers reflect Multi-Asset Solutions’ strategic assumptions as of September 30, 2022. Past performance does not guarantee future results, which may vary.
This said, we see numerous opportunities for patient investors who should proactively consider three key themes: left-tail risk, asset class implementation, and active management.
Quick fixes to issues like rising inflation and hawkish monetary policy are unlikely, forcing investors to rethink expected returns and the portfolio volatility they must endure to get them. On top of this reset, the traditional negative correlation between stocks and bonds has temporarily broken down, as both have sold off at the same time. To manage portfolios in this environment, investors need to understand their left-tail risk, because the only thing worse than being down is being down and surprised.
The left tail refers to one of two end portions of a normal distribution curve, which represents the probabilities of a range of portfolio returns. Both the left and right tails represent the least frequent yet most extreme outcomes. In the case of an investment portfolio, left-tail risk refers to the risk of experiencing unlikely yet severely poor returns, and right-tail risk refers to the risk of experiencing unlikely yet severely positive returns. Ideally, investors want to minimize left-tail risk while giving themselves the opportunity to benefit from right-tail risk.
Let’s quantify left-tail risk into numbers by looking at a well-diversified European pension portfolio as a case study. The below portfolio has an expected long-term volatility of 10.1%. This stat means that the majority of outcomes (68%, or one standard deviation to be precise) falls within ±10.1% of its expected return of 6.1%. Still, to better grasp just how bad outcomes could be, we consider the value at risk (VaR), which is -18.1%. This metric suggests that in 99% of one-year periods, we would not expect the portfolio to lose more than -18.1%. This metric accounts for the reality that returns are not normally distributed, unlike the usual standard deviation metrics which relies on a simplistic normal distribution.
Source: SAS Portfolio Strategy/Goldman Sachs Asset Management. For illustrative purposes only. Alpha and tracking error assumptions reflect Multi-Asset Solutions’ estimates for above-average active managers and are based on a historical study of the net-of-fee results of active management. Strategic long-term assumptions are subject to high levels of uncertainty regarding future economic and market factors that may affect future performance. They are hypothetical indications of a broad range of possible returns. All numbers reflect Multi-Asset Solutions’ strategic assumptions as of September 30, 2022. Expected returns are estimates of hypothetical average returns of economic asset classes derived from statistical models. There can be no assurance that these returns can be achieved. Actual returns are likely to vary. Please see additional disclosures. Risk Free Rate is calculated as the forward-looking expected return on cash. Past performance does not guarantee future results, which may vary. Please see additional disclosures.
But what about the remaining 1% of one-year periods in which drawdowns exceed that threshold? These are the outcomes clustered in the left tail of a portfolio’s distribution curve. For example, the worst historical drawdown this particular asset allocation has experienced was -40.9% during the depths of the Global Financial Crisis, far outside of -18.1%. During times when markets drive portfolios deep into the left tails, we find that correlations tend to converge, reducing the diversification of traditional asset classes. In the years ahead, we believe investors will need to look more closely at left-tail risk, understand what happens when correlation benefits break down, and consider adding investments that can potentially help to mitigate the risk of extremely poor outcomes.
Certain asset classes dampen volatility and reinforce a long-term total portfolio perspective, and these are benefits that become even more tangible during a difficult market environment. One, equity buy-write strategies may help investors dampen volatility and generate income in an environment that is less supportive of risk assets. The strategy involves simultaneously owning a diversified portfolio of stocks while writing index call options to cover some of the long exposure, striving for higher lows in exchange for lower highs. In fact, the monthly volatility of a typical buy-write strategy has been, on average, 5.5 percentage points (pp) lower than that of the S&P 500 over the long term. And the premiums generated from call-writing can provide enhanced income. When expected volatility is high, so too are the option premiums, and this income generation may act as a buffer to market selloffs.
Another asset class that may also dampen the severity of equity pullbacks is multi-strategy liquid alternatives. The asset class seeks to provide broad exposure to the hedge fund universe but with more liquidity compared to its private counterpart. When added to a diversified portfolio, liquid alternatives have historically helped manage drawdowns during periods of market stress. During instances in which the S&P 500 has fallen -15% or more from its peak, diversified liquid alternatives have outperformed US large cap equities by between 8 and 45 pp.
Finally, including an allocation to private assets within client portfolios can help maintain a long-term investment mindset. With capital lockups ranging from 10–15 years, private asset investments tend to be illiquid and therefore require a careful approach to cash flow management. But it is these lockups that can help clients stick to a long-term strategic asset allocation. And as we move into today’s less favorable market cycle, private assets can potentially enhance returns above those of public equities through exposure to alternative betas and additional alpha opportunities.
An environment of more deviation, differentiation, and volatility is ripe for active managers to seek higher returns. While the benchmark for large cap equities tends to be the S&P 500 and is usually reliable, not all asset class benchmarks are efficient. Persistent market volatility gives active managers the opportunity to outperform benchmarks. Additionally, active managers may be better positioned to address left-tail risk flexibly. For example, an active manager may be able to trade options for downside protection.
Of course, conversations about tracking error typically flow from those about active management, and rightfully so. Tracking error, or active risk, is the cold, hard measurement we use to control our expected experience when choosing investment products. For example, the tracking error of the largest active emerging market equity fund is 5.1%, based on five years of data as of October 2022. This measure means that 68% of the fund’s active returns have fallen within 5.1% of its benchmark’s returns. But investors must be prepared for outcomes outside of a target range that stray further from the benchmark. This uncertain market environment has intensified the importance of active risk as a barometer for the client experience, with more active risk meaning a more varied experience that may be harder for investors to tolerate.
Therefore, investors may seek to lower tracking error and improve their information ratio, which is the excess return over tracking error. To do so, investors might consider combining complementary managers to maximize returns per unit of active risk. Specifically, we believe that identifying managers with low correlations of excess returns may prove beneficial, as blends of these funds will likely have lower active risk and higher information ratios than those of funds on their own will. Our analysis shows that blending two funds can mitigate active risk and potentially improve the investor experience. Notice how blending the two funds together has improved the performance of the underperformer and has reduced active risk.
Source: Morningstar as of June 30, 2022 and SAS Portfolio Strategy/Goldman Sachs Asset Management as of July 29, 2022. For illustrative purposes only. All statistics are derived from monthly returns published by Morningstar. Benchmark index used is the MSCI Emerging Markets. Currency perspective of the analysis is USD. Past correlations are not indicative of future correlations, which may vary. The returns represent past performance. Past performance does not guarantee future results. The Fund's investment return and principal value will fluctuate so that an investor's shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance quoted above. Please visit our Web site at: www.GSAMFUNDS.com to obtain the most recent month-end returns. Please see the external manager fund company website to obtain the most recent month-end returns. Mutual funds referenced herein are provided at your request for informational purposes only and should not be construed as investment advice or an offer or solicitation to buy or sell these securities by Goldman Sachs.
Above all else, we continue to advocate for investment discipline: staying invested might just be an investor’s best option in a volatile market cycle. It may help to take a page from the institutional investment playbook, which involves setting ranges for allocation weights to given asset classes. These can be driven by an investor’s long-term goals and may help to take emotion out of the equation. For example, such an approach may help investors resist the urge to overreact to large market moves or sit on the sidelines. Importantly, the strongest one- and two-year recoveries of the S&P 500 typically follow troughs.
Source: SAS Portfolio Strategy/Goldman Sachs Asset Management, as of December 31, 2021. Drawdowns shown are all S&P 500 drawdowns since 1970 of at least 15% in magnitude for which there are at least 2 years of performance following the trough, excluding Mar 2020. Past performance does not guarantee future results, which may vary. These illustrative results do not reflect any Goldman Sachs Asset Management product and are being shown for informational purposes only. No representation made that an investor will achieve results similar to those shown. The performance results are based on historical performance of the indices used. The results will vary based on market conditions and your allocation.
In the one year following the COVID-19-induced market trough in March 2020, the S&P 500 achieved close to 80% total returns. If investors today remain anchored to current market volatility and sell indiscriminately, they might find themselves with underperformance versus a buy and hold strategy. Importantly, markets tend to reward patient investors who maintain a long-term mindset.
In fact, investing for six months or more can significantly improve the likelihood of success. On any given day, there is a 54% chance the S&P 500 will deliver a positive return. Essentially, a coin toss. However, extending the investment period to six months or one year increases the probability to 73% and 81%, respectively.
As a final reminder, volatility cuts in both directions: the best and worst market days often appear in clusters. Timing a bear market bottom can be challenging, but encouragingly, the cost of being early has historically been low. Our math shows that it takes investors, on average, just 49 trading days to completely recover if they are 15% early to the bottom of a bear market; just 10 days if they are 10% early; and just two days if they are 5% early. Certainly, a degree of de-risking may be appropriate depending on an investor’s circumstances, but we believe that attempting to time the market may end with gains left on the table.
In the current macroeconomic environment, we expect the next decade’s market cycle to exhibit elevated volatility. This new market regime will require investors to pay attention to left-tail risk and consider new asset class allocations and active management. Most importantly, we believe investors will need to demonstrate investment discipline and stay invested whenever appropriate. Our firm belief is that a long-term, total portfolio perspective will always help investors navigate volatile market environments.
Committed to providing you with the insights you need to build your practice.
1 As of November 30, 2022
Volatility is the variation in the price of a financial instrument.
Left-tail risk refers to the risk of unlikely yet extremely negative portfolio outcomes.
Value at risk quantifies the extent of possible financial losses within a portfolio at a certain confidence level.
Alpha refers to returns in excess of the benchmark.
Tracking error/active risk is the divergence between the price behavior or a portfolio and the price behavior of a benchmark.
Information ratio is the risk-adjusted returns on a portfolio in relation to a specified benchmark.
An equity market drawdown is a period of falling equity prices.
"US Agg Bonds are represented by the Bloomberg Aggregate Bond Index, an unmanaged diversified portfolio of fixed income securities, including U.S. Treasuries, investment grade corporate bonds, and mortgage backed and asset-backed securities.
US Large Cap is represented by the Standard & Poor’s 500 Composite Index of 500 stocks, an unmanaged index of common stock prices.
EAFE Equity is represented by the MSCI EAFE, an unmanaged, unhedged, market capitalization weighted composite of securities in 21 developed markets.
Global High Yield is represented by the Bloomberg Global High Yield Index, which provides a broad-based measure of the global high-yield fixed income market.
EM Debt is represented by the JPM EMBI Global Composite, an unmanaged index tracking dollar-denominated debt instruments issued in emerging markets.
Global Real Estate is represented by the FTSE EPRA/NAREIT Developed Index, a benchmark tracking the performance of listed real estate.
Intl Small Cap is represented by the S&P Developed ex-US Small Cap Index, which covers the smallest 15% of companies from developed countries (excluding the US) ranked by total market capitalization.
EM Equity is represented by the MSCI Emerging Markets Index, a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets."
The S&P 500 Index is the Standard & Poor's 500 Composite Stock Prices Index of 500 stocks, an unmanaged index of common stock prices. The index figures do not reflect any deduction for fees, expenses or taxes. It is not possible to invest directly in an unmanaged index.
The VIX Index is the Chicago Board Options Exchange’s CBOE Volatility Index and represents a popular measure of the stock market’s expectation of volatility based on the S&P 500 Index.
The MOVE Index is the ICE BofA Merrill Lynch Option Volatility Estimate Index and represents the future volatility in US Treasury yields implied by current prices of options on Treasuries of various maturities.
Indices are unmanaged. The figures for the index reflect the reinvestment of all income or dividends, as applicable, but do not reflect the deduction of any fees or expenses which would reduce returns.
Investors cannot invest directly in indices. The indices referenced herein have been selected because they are well known, easily recognized by investors, and reflect those indices that the Investment Manager believes, in part based on industry practice, provide a suitable benchmark against which to evaluate the investment or broader market described herein.
Risk Considerations and General Disclosures
Equity securities are more volatile than fixed income securities and subject to greater risks. Small and mid-sized company stocks involve greater risks than those customarily associated with larger companies.
Investments in foreign securities entail special risks such as currency, political, economic, and market risks. These risks are heightened in emerging markets.
Emerging markets securities may be less liquid and more volatile and are subject to a number of additional risks, including but not limited to currency fluctuations and political instability.
Investments in fixed-income securities are subject to credit and interest rate risks. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline in the bond’s price. Credit risk is the risk that an issuer will default on payments of interest and principal. This risk is higher when investing in high yield bonds, also known as junk bonds, which have lower ratings and are subject to greater volatility. All fixed income investments may be worth less than their original cost upon redemption or maturity.
Bonds are subject to interest rate, price and credit risks. Prices tend to be inversely affected by changes in interest rates.
Although Treasuries are considered free from credit risk, they are subject to interest rate risk, which may cause the underlying value of the security to fluctuate. Income from municipal securities is generally free from federal taxes and state taxes for residents of the issuing state. While the interest income is tax-free, capital gains, if any, will be subject to taxes. Income for some investors may be subject to the federal Alternative Minimum Tax (AMT). The above are not an exhaustive list of potential risks. There may be additional risks that are not currently foreseen or considered.
Buy-write strategies are subject to market risk, which means that the value of the securities in which it invests may go up or down in response to the prospects of individual companies, particular sectors and/or general economic conditions. They are also subject to the risks associated with writing (selling) call options, which limits the opportunity to profit from an increase in the market value of stocks in exchange for upfront cash at the time of selling the call option. In a rising market, the strategy could significantly underperform the market, and the options strategies may not fully protect it against declines in the value of the market.
Investors should also consider some of the potential risks of alternative investments:
The above are not an exhaustive list of potential risks. There may be additional risks that are not currently foreseen or considered.
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Date of First Use: December 15, 2022 298377-OTU-1702327