In this edition of CA Answers, two members of our Global Investment Research team share their differing perspectives on whether investors should temporarily de-risk portfolios today. Sean McLaughlin argues that diversified portfolios incorporate shock absorbers already, and that temporarily boosting tilts to defensive assets is likely to be counter-productive. Eric Winig agrees that market timing is generally “a mug’s game,” but argues that given today’s rich valuations and central bank influence on markets, the rationale for raising cash is sound.

Sean McLaughlin: No. Most investors already have defensive elements in their well-diversified portfolios, few defensive assets today are particularly appealing, and to add more defense in anticipation of an equity market fall is actually a two-pronged decision—not just when to get out, but when to get back in. Diversified portfolios are constructed to be robust through a variety of market conditions (that is certainly not to say they will excel in all of them), and cycling back and forth between risky and defensive assets is unnecessary and usually counter-productive.

Let’s start with the perennial problem that trips up most efforts to de-risk portfolios: timing the re-entry. Anecdotally, I would posit that many investors that lower their equity exposure end up eventually adding it back at higher equity price levels than where they originally de-risked. Even for those few investors that successfully time a de-risking decision (rather than getting out in advance of an event that impacts markets less than feared, such as the H1N1 virus outbreak in 2009 or the US debt ceiling standoff in 2011), they must now also time their re-entry well. My colleague Eric will imply that investors who load up on cash today will eventually have an opportunity to deploy it to buy cheaper equities at some point in the future. He is likely correct about the opportunity—equity markets are volatile—but if any investors can execute this consistently, I’ve not yet met them. Most investors get limited practice with pulling rabbits out of their investment hats, and should hesitate before committing to producing two such hares.

Secondly, what would investors boost their allocation to if they wished to lower their risk level? While diversified portfolios already have allocations to many defensive styles and asset classes, few of these options today are tempting places to add money for investors looking to trim their exposure to broad equities. Consider:

• The excess returns of low-beta equities are closely linked to bond yields, so a Taper Tantrum 2.0 might temporarily invert the low-beta equation (and some investors worry that these popular stocks are now an increasingly crowded trade).
• Equity hedge funds over the past three years have delivered 57% of the volatility of the S&P 500 Index, yet only 31% of the index’s return. There is still a role for long/short hedge funds managed by exceptionally talented managers offering differentiated portfolios at reasonable terms, and the value style is out of favor rather than dead. That said, miniscule cash yields, crowding, and other headwinds limit enthusiasm for boosting allocations.
• Should US high-yield bonds now be called “relatively higher-yield bonds?” Because in an absolute sense, their 6.5% yield is nothing to get excited about (even if defaults plateau rather than continue to rise).
• Sovereign bond yields are near record lows and cash yields remain mired near zero. Bond yields could fall further in a crisis . . . or an eventual return to historical norms could spark a crisis.

While allocations to many of the above strategies and asset classes remain appropriate, for investors that value diversification as Cambridge Associates does, temporarily de-risking by moving assets from an asset class that is core to the investment policy (global equities) to one of these strategies requires confidence that the alternative will outperform equities.

Finally, a diversified portfolio already contains many defensive elements. A simplified hypothetical portfolio consisting of 60% global equities, 20% US bonds, and 20% hedge funds has an annualized standard deviation over the past three years of less than 8%.
The success of the investment model pioneered by endowments relies in part on high exposure to equities through the full cycle. The most successful institutional investors spend lots of time getting their long-term strategic asset allocation right, sourcing the best available managers and sticking with them though their inevitable rough patches, and seeking out ways to implement their investments efficiently and cheaply. Most don’t have the time or the differentiated ability to accurately sidestep each market move and then re-engage with risk assets in a timely fashion. Neither, most likely, do you.

Eric Winig: Yes. The current market is not only overvalued across most risk asset classes, but has, in its growing fealty to central bankers, set itself up where the mere hint of a shift in central bank policy can roil markets. Further, near-record levels of leverage in systematic trading strategies are reminiscent of the situation that prevailed in August 2015, when China’s “devaluation heard round the world” caused global markets to virtually seize up.

Sean is correct that market timing is a mug’s game, and that investors who hope to hit long-term spending targets must, as a general rule, maintain allocations to risk assets to achieve desired returns. However, the current period may be the exception that proves the rule.

How expensive are markets? Depends on who you ask, but I find a simple bootstrap method to be the most effective. For example, the S&P 500 currently yields about 2.1%, and a reasonable expectation for long-term real dividend growth is about 1.5%, meaning investors can expect returns of a bit less than 4% real, assuming valuations stay the same. Unfortunately, given that the Shiller price-earnings ratio is at 27 times earnings—higher than at any point outside the 1929 and 1999 bubbles (and their aftermath), and roughly equal to its 2007 peak—multiples a decade hence are likely to be lower, perhaps much lower, than current levels.

None of this is new, so why the need to be concerned now? In my mind, similar to how the market sent warning signals in late 2007 and early 2008, with sharp but quickly retraced sell-offs even as economic fundamentals were deteriorating, market action in recent months is worrisome. The post-Brexit reaction, when markets sold off for a whole two days, then not only recouped their losses but pushed on to new heights based seemingly on the idea that central bankers would do . . . something, was to me a clear sign that risk assets have become entirely in thrall not only to the actions of central banks, but also to even what they might, perhaps, deign to do. (I discussed this in a July research brief, Brexit: Outlier or Harbinger?) In other words, the reality of Brexit, which could lead to further fracturing of the European Union, was deemed less important than the fact that Mario Draghi was simply not interested in seeing equities fall.

All of which brings us to the past couple of weeks, when formerly quiescent markets were stunned by the Bank of Japan’s “trial balloon,” in which BOJ governor Haruhiko Kuroda worried aloud about the effects of negative interest rates across the curve, causing some analysts to predict a “reverse Operation Twist,” where the BOJ would seek to steepen the curve by selling long-dated maturities and buying short ones. This caused a mini-panic on September 9, as selling in bonds spilled over to equities, commodities, and even precious metals. As another colleague put it during the sell-off: “days like today are what really scare me. Not that we are down a whopping 1% of course, but that rate hike odds are the driving narrative and not a single asset class is green (unless you count VIX).”

Finally, according to Marko Kolanovic, Global Head of Derivative and Quantitative Strategies at J.P. Morgan, and one of the few to correctly warn of the epic volatility in August 2015, “leverage in systematic strategies such as Volatility Targeting and Risk Parity is now near all-time highs. The same is true for CTA funds who run near-record levels of equity exposure.”

What to do, as Sean correctly points out that many defensive strategies are expensive? Not to sound like a broken record but . . . cash anyone?

Sean McLaughlin and Eric Winig are Managing Directors on the Cambridge Associates Global Investment Research team.