Tom Lee

The Wuhan coronavirus outbreak began with 50 known cases in mainland China in December. It’s since resulted in over 78,000 known cases—2,120 fatal—across over 27 countries, with 14 known cases in the United States as of this writing. The US government has imposed a ban on foreign nationals traveling from China, a move that China’s foreign ministry has slammed as “fear and overreaction.”

But with the number of cases rising by the day and the word pandemic dominating headlines, caution seems prudent at this point, notes Tom Lee, Chief Investment Officer, Equities and Derivatives at Parametric.

Mr Lee says: “For their part, investors are growing fearful of the implications this rapidly spreading disease may have on global growth and ultimately the financial markets. Worldwide pandemic fears led the Dow to open 1,000 points lower on Monday, while the VIX, which measures global market volatility, rose 40%.

“We can’t know just yet what the world will look like after the worst of the coronavirus outbreak has passed. What we can do is recommend that investors adopt the disciplined and diversified approach that we bring to our own portfolio decisions. Even in the face of a health crisis, disciplined investors can keep their portfolios in good shape.

“Let’s take a closer look at the outbreak and how it may guide your investing strategy.”

What does the coronavirus mean for equities?

Investors are no doubt thinking back to previous pandemics like SARS, which spread to over 8,000 patients over a nine-month period before being vanquished in 2003. While markets were jumpy at the beginning of the SARS outbreak, the ultimate economic effects were minimal. Growth in China dipped briefly and then rebounded; the impact on the rest of the world was negligible. But that was in 2003, when China accounted for 4% of global growth. That number has since increased to 16%. For that matter, coronavirus infections and fatalities have far surpassed those of SARS. One epidemic may not hold as many lessons for another epidemic as investors would like to believe.

Global equity performance during the SARS epidemic

For illustrative purposes only. It is not possible to invest directly in an index. Not a recommendation to buy or sell any security.

It’s difficult to predict at this point whether the coronavirus will create the global economic slowdown that the IMF fears. But it’s already disrupting supply chains around the world. Wuhan is the capital of Hubei province, a top global auto manufacturing hub. General Motors, Volkswagen, and Toyota have been forced to shut down their local factories while the city of 11 million remains locked down. Hyundai has become the first automaker to halt production outside China because of the virus; critical components built in Wuhan can’t get through to the company’s South Korea plants.

And this isn’t a problem just for automakers. Sourcing new facilities and parts at cost-competitive levels will prove challenging for any company operating in Wuhan. Companies as diverse as Airbus, Siemens, Apple, and Ericsson have been forced to delay product deliveries and set up crisis-management teams. Apple announced last week that it wouldn’t meet current quarter revenue projections; the outbreak has kept shoppers away from electronics stores and forced the company’s Chinese facilities to cut iPhone production.

What does the coronavirus mean for fixed income?

Past pandemics have followed a pattern of emergence, peak, and wane. Uncertainty of the timing and scope of the peak tends to promote risk-off behavior. This time is no different. Since reports of a sharp rise in cases in China on January 20, the 10-year Treasury yield has fallen from 1.82% to 1.58%, despite economic data indicating that the long US economic expansion will continue.

Concerned that the virus will slow the global economy, investors may be looking for central banks to step in. According to the CME FedWatch Tool, futures are predicting a 25 bps rate cut from the Federal Reserve by Q3 2020. Fed chairman Jerome Powell says to expect some economic effects in the US but adds that it’s too early to say if they’ll be persistent or material.

How should investors deal with the coronavirus epidemic?

It’s vital to remember how early we are into the coronavirus event. Even as nations take action to keep the virus out, most experts expect the number of cases to increase, including outside of China in countries like the US. Anxiety will likely remain high as epidemiologists work to develop a vaccine and more information becomes known in the coming weeks. Both known and unknown unknowns are numerous.

It’s always important to prevent heightened emotions from driving investment decisions. Sticking to long-term objectives and maintaining healthy levels of geographic and sector diversification in your equity allocation are principles worth keeping. As China has grown into the world’s second-largest economy, its position in emerging markets benchmark indexes has become more concentrated. Diversification helps investors avert concentration of risk; the fallout of the coronavirus brings this benefit into sharp focus.

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Raewyn Williams

Lifecycle investing is becoming an increasingly valuable option for superannuation funds aiming to construct a long-term default asset allocation strategy for their members.

Research by the global specialist implementation manager Parametric shows that about 37% of total MySuper assets and 31 of the registered 111 MySuper products offer lifecycle investing. Although these assets and products sit predominantly in retail superannuation funds, there is growing interest among industry and corporate funds.

Tom Lee, Parametric Managing Director (Investment Strategy and Research) and Raewyn Williams Managing Director (Research, Australia) say lifecycle strategies operate on the uncontroversial premise that with increasing age, fund members have a lower appetite for risky assets in their portfolios.

“So, the fund gradually de-risks members’ portfolio. What starts as a reasonably high-risk portfolio (high allocation to growth assets like equities) ends up as a low-risk portfolio (high allocation to defensive assets like cash and fixed income) as the mix of assets becomes more defensive assets over time.”

“Differences in lifecycle approaches reflect nuances such as when the de-risking starts, how often it occurs and how graduated the asset allocation shifts are, but the essential principle of using age, or more precisely earnings lifecycle as a proxy for risk appetite, is the same.”

Lee and Williams argue that lifecycle strategies can be a powerful tool for many funds – and they can be sharpened further, especially regarding the use of asset classes. Their new research paper, “Defensive Equity: A Sharper Tool for your Lifecycle Toolkit”, contends that adding a defensive equity strategy to mitigate the “rather harsh” leap from equities to fixed income could deliver better absolute and risk-adjusted returns to retired members, including a higher income stream in retirement. [The defensive equity strategy Parametric uses in this analysis reduces volatility in a super fund’s equity portfolio while accessing a substitute source of income to replenish account balances.]

“These benefits are delivered while continuing to significantly de-risk the portfolio through time, with liquidity and transparency preserved in the portfolio.”
“Funds that add this sharper tool to their lifecycle portfolio take a crucial step toward genuinely addressing retirees’ ‘triangle of needs’ identified in the Financial Systems Inquiry —income, risk management and flexibility.”

The research compares a “classic” lifecycle portfolio that goes from 80% growth assets to 80% defensive assets over a 30-year period to a portfolio that also begins with 80% growth assets but substitutes a defensive equity strategy for some bonds. The research stress-tested the results to explore best and worst case scenarios and as well as the expected mean (most likely) outcomes across a range of portfolio attributes. The outcomes were modelled before fees but net of transaction costs.

“We explored two hypothetical lifecycle strategies for super fund members and our modelling led us to believe that, pre-fees, the portfolio using a defensive equity strategy could deliver higher total returns each year on average to members, indicated by an expected mean return of 6.72% annually to members, which is around 1% more than the classic lifecycle strategy expected mean return of 5.71%.”

“Using a defensive equity strategy in a lifecycle approach also produced an expected 18% higher annual income, based on our simulations, which is noteworthy given last week’s reaffirmation by the Government in the Federal Budget that new ‘CIPR’ retirement products must meet members’ income needs.”

Strikingly, Parametric’s research also showed the lifecycle portfolio using a defensive equity strategy to have not only better income and growth characteristics, but also better risk characteristics, measured by volatility and maximum drawdown.

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This is the definitive conclusion of a research report by U.S. fund manager Parametric, says Raewyn Williams, Parametric Director, Research & After-Tax Solutions, and Managing Director, Investment Strategy & Research, Tom Lee, who describes volatility as “two problems, not one” that requires a strategic response from superannuation funds.

The report, titled A Wide Angle Lens View of Volatility: Managing the Journey and the Destination, details why superannuation funds need to smooth the fund member’s journey and prevent the erosion of their retirement balances.

The report compares two hypothetical $10 million equity portfolios, one with volatility and one without, that illustrates a return drag from volatility of 61 basis points occurring over a five-year period.

Williams and Lee comment, “This is the ‘wide-angle lens’ view of volatility that superannuation funds should take. Our research argues that in addressing volatility, funds can, and should, do better than simply address the journey problem – they need to find solutions to address the destination problem as well.”

“Larger portfolios, higher returns, higher volatility or longer time periods can all increase this ‘leakage’.

This return drag from volatility is akin to other hidden leakages in implementation such as fees, taxes and transaction costs that furtively and assiduously eat away at member returns over time. Current solutions do not typically address these leakages because they are usually not measured, disclosed or well understood.”

Williams and Lee explain that superannuation funds typically have five strategic responses to volatility:

• Moving to a formal risk-adjusted returns investment approach;
• Favoring equity portfolios with innate defensive characteristics;
• Purchasing downside protection;
• Purchasing tail risk protection;and,
• Adopting volatility dampening strategies.

“The problem with these approaches concerns the member’s retirement balance. Either the portfolio continues to live with significant volatility (and the volatility drag to returns) or it costs so much to reduce the volatility that the member’s returns will be even lower than if the portfolio experienced the full volatility drag.

In our example comparing two hypothetical strategies, solutions that cost more than eight or nine basis points a year for downside or tail risk protection or 11 basis points a year for targeted volatility dampening could leave a member worse off in terms of retirement balance than simply maintaining a portfolio with full, unmitigated volatility.”

In these circumstances the authors argue a better “defensive equity” solution is one where superannuation funds do not have to make such difficult choices between journey and destination, or make assumptions about member preferences about journey or destination.

“We propose a defensive equity solution designed to reduce volatility in a superannuation fund’s equity portfolio as well as providing a substitute source of income to replenish account balances. Our solution can be implemented over Australian or international equity portfolios.

We confront the journey problem by de-risking a sizeable part of the portfolio from equities into defensive assets and the destination problem by introducing a put and call writing overlay that positions the fund on the generously-priced sell-side of the option protection (and speculation) other funds are buying.

We seek to avoid the costliness of buying protection by being on the sell-side, and also other issues like liquidity and counterparty risk.

The strategy substitutes some equity risk premium with a consistent volatility risk premium. The volatility spread on the ASX 200 has averaged 4.1% per year over the past 11¼ years (our backtest period). We use the same approach in our live U.S. and global Defensive Equity strategies.”

Williams and Lee say these results demonstrate how, with innovation, it is possible and practical to circumvent a difficult choice superannuation funds would otherwise face, and address both the journey and destination problems simultaneously created by volatility.

“Members will no doubt take a ‘wide angle lens’ view of their superannuation experience, caring equally about their journey and destination. Funds should be excited about solutions that do not ask them to choose between the two, but neatly address both.”

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Tom Lee

Parametric Portfolio Associates LLC (Parametric), a majority owned subsidiary of Eaton Vance Corp., has announced the addition of a new Liquid Alternative strategy to their suite of Volatility Risk Premium (VRP) strategies.

The Parametric Liquid Alternative strategy is designed to provide investors with a diversifying risk premium that targets risk-adjusted returns similar to many hedge funds.  The strategy employs a mix of fully collateralized S&P 500® Index options, creating an effective beta targeted by many hedge funds, but without the complicated structure, leverage, illiquidity or high fees typically associated with them.

The Parametric VRP strategies include a spectrum ranging from covered calls to cash-secured put selling, and includes hybrid strategies which vary the underlying portfolio as well as the mix of options. All of these strategies are designed to target a clients’ specific risk/return objectives.

Tom Lee, Managing Director – Investment Strategy and Research, Parametric Minneapolis Investment Center states, “We are launching the Liquid Alternative strategy to meet a growing demand for strategies that seek to reduce volatility through the introduction of a diversifying risk premium.  Additionally, our clients have asked us to deliver a liquid, low cost solution for core hedge fund allocations.”

“Parametric has over 20 years of experience managing volatility risk premium strategies, with assets under management more than doubling over the last three years; growing from $4.5 billion at the end of 2012 to nearly $10 billion as of 31 December, 2015.” Mr. Lee adds, “Our research and experience have shown that employing a disciplined, long-term approach can successfully generate incremental returns over time, and can be more effective than other, more tactical strategies.

Designed to consistently access the persistent VRP associated with selling equity index options, these strategies are implemented using systematic, rules-based methods. A disciplined, systematic approach also has the benefit of removing the challenge of emotions commonly associated with actively managed strategies.”

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