Update: NEIRG Investment Strategy in a Dynamic Market

by Tom Kennedy, CFA® | Nov 19, 2018

After a decade of double-digit market returns, the S&P 500 has hit a choppy period, modestly pulling back from all-time highs. NEIRG has proactively responded to these turbulent conditions by adding to defensive and alternative allocations and by attempting to reduce each portfolio’s risk. Through raising cash and buying defensive positions, we have worked to reduce the impact that further market declines would have on our portfolios. Going forward, we expect to participate to a lesser extent if the market continues its upswing but to experience a smoother ride if the market turns lower.

Market Conditions

After reaching all-time highs in September, the S&P 500 turned over in October, pulling back about 10% from its peak before recovering some of its lost ground. Volatility has picked up with the CBOE Volatility Index (broadly known as the VIX) above 25 for the first time since February (1). And since the recent September peak, market volatility has been evident in that the S&P 500 has experienced at least 13 days of more than a 1% move and at least 5 days with more than a 2% move (as of this writing) (1). Bond markets have also been pressured, with the Barclays Aggregate Total Return index (representing the broad fixed income market) declining 2.4% this year (1). During this downturn, there haven’t been many places for investors to hide.

Percentage Return for S&P 500 Index and Barclays Aggregate Bond Index: YTD 2018 Performance

Source: Bloomberg
 
NEIRG’s Positioning

We have proactively positioned our portfolio to hold up during this period of pronounced volatility. It is difficult to overcome negative returns; for example, it takes a 25% gain to overcome a 20% loss, and a 100% gain to make up for a 50% loss. Because of the asymmetric nature of risk, the best strategy is often to avoid periods of heightened volatility.

The firm has adjusted its positioning to help mitigate the recent risks facing the markets. We have been taking profits on our investments in growth-oriented funds, technology funds and broad market funds, which have benefitted from an extended period of outperformance.

We have used these proceeds to add defensive sectors and alternative investments, while increasing our allocation in cash. Cash acts as a shock absorber for a portfolio; a 10% allocation to cash will directly reduce investment portfolio volatility by about 10%. Additionally, during volatile times, having increased cash levels allows us to be more tactical in the event of a timely investment opportunity.

These moves reflect our view that equity markets could experience muted returns through 2019 and that fixed income could continue to be pressured. Over the next year, the market may face continuing headwinds from rising interest rates, trade tariffs and geopolitical risks, which might increase the probability that the market could take another leg lower.

Defensive Sectors

To help protect our downside risk we have added to defensive sectors such as utilities, consumer staples and health care. These areas of investment tend to have less economic sensitivity than the rest of the stock market; consumers would continue to pay for essentials such as food, medical care and electric bills during periods of economic weakness. This is reflected in the performance of these sectors during recessions, with their indices outperforming during recent bear markets.

2000-2002: Tech Bubble returns of S&P 500, MSCI US Utilities, Consumer Staples, Health Care indices

Source: Bloomberg
 
2008: Great Recession returns of S&P 500, MSCI US Utilities, Consumer Staples, Health Care indices

Source: Bloomberg
 
Adding portfolio exposure to these resilient sectors also helps reduce risk during non-recessionary periods. During periods of heightened volatility, healthcare, utilities and consumer staples tend to act as ballast for a portfolio because they generally experience less volatility and more modest drawdowns than the market. This exposure helps keep returns more predictable, with less upside in up markets but less downside in down markets.

Alternatives

Additionally, we have increased our allocations to alternative investments, utilizing MLPs, Market Neutral and Long/Short Equity funds. We have found the properties of these instruments to be advantageous during times such as these.

MLPs, for example, are companies that own pipelines, collecting “tolls” on the volume of oil going through them. They give investors an attractive yield with the potential for growth over time, also featuring a low correlation to the broad market and fixed income investments. Combining attractive returns and low correlation helps to improve the risk profile of a portfolio, as an uncorrelated asset may be flat or up when other assets are down.

Market Neutral and Long/Short Equity funds buy equities (or other assets that act like equities, such as convertible bonds) and hedge their market risk by shorting (betting against) the broad market or individual stocks. These funds give top portfolio managers the ability to add value through security selection. They also allow the fund to outperform on the long or the short side, while reducing downside risk by hedging. Market Neutral funds also benefit from a low correlation to equities and fixed income, acting more like a fixed income investment, delivering mid-single-digit returns with modestly more risk than bonds. Long/Short funds tend to have less risk than the stock market, underperforming during market rallies and outperforming during downturns, with top funds earning an attractive return over a full market cycle.

Summary

In conclusion, NEIRG has been actively making changes to reduce the risk and economic sensitivity of our portfolios. The changes to our investment approach could result in diminished upside potential; however, we believe that our strategy’s inclusion of defensive allocations, alternative investments and cash (when appropriate) will perform comparatively well in these choppy markets. We plan to continue monitoring the ongoing market conditions, responding when prudent to position our clients for relative success in a dynamic investment environment.
 
 
(1) Source: Bloomberg