Uncertainty in markets can also mean opportunity

By Greg Davis, President and Chief Investment Officer

Super and retirement

Pending tariffs might mean greater risk in the markets, but also opportunities.

Ongoing tariff negotiations leave many unanswered questions, adding to uncertainty in the markets. Uncertainty can be unsettling, no doubt, particularly for investors in countries impacted by the proposed tariffs, and it can lead to greater volatility as the markets process the news.

But uncertainty is nothing new. Having been in the investment industry for nearly 30 years, I’ve faced uncertainty in the markets many times, navigating downturns and upswings. We should look at uncertainty beyond its potential for volatility—it also highlights opportunities to either mitigate risk or generate alpha.

 

Diversification to mitigate risk

Mitigating risk is the more apparent issue for investors. With rare exceptions, fixed income has generally provided ballast against equity risk. And, as our economists have pointed out, bonds are particularly attractive in today’s environment—a return to sound money where interest rates generally exceed the average rate of inflation. Given that and stretched valuations for some equities, a balanced portfolio looks more prudent than it has in decades.

Every downturn, disruption, or period of uncertainty has also unlocked opportunities.

And let’s not forget that diversification should not be just across asset classes but also within each asset class. The potential impact of tariffs will be uneven across regions, sectors, and companies—the ripple effect unknown. Investors’ natural tendency for home bias might be particularly counterproductive in an environment where we expect greater dispersion of returns. Globally diversified portfolios—not too concentrated in any one region or sector—are better suited to mitigate risks.

 

Harnessing disruption to generate alpha

Uncertainty can lead to disruption. In theory, periods of disruption should be an advantage for active managers. Greater volatility translates to greater dispersion of returns and more opportunities for active managers to add value relative to benchmark indexes.

In practice, that doesn’t always happen, often because managers swing for the fences, taking on undue risk to deliver returns above costs. Adding value, especially during periods of disruption, requires skilled, low-cost active managers who can be judicious in their security selection without the pressure of having to compensate for their fees.

This is particularly true in the fixed income market. There are more than 30,000 unique securities in the Bloomberg Global Aggregate Index. This presents both a larger opportunity set and an imposing challenge for bond portfolio managers. Those with access to specialised teams providing deep credit research and insights have an advantage in being strategic and opportunistic.

I should add that the advantages of credit research and proprietary insights can span to index funds as well. Because bond indexes typically have thousands of securities, full replication in a real-world portfolio is impractical. Bond index funds that sample can use credit research in picking which bonds to include and—more importantly—which bonds to exclude. (Avoiding the losers can make more of a difference to the bottom line than picking the winners.) This practice further helps consistency in performance over the long run, over multiple market cycles.

 

Costs change the risk-return profile

Low costs are a further advantage at multiple levels, for both active and passive. The obvious one is that costs directly detract from returns, and proportionally more so for bond portfolios than for stock portfolios. Keeping costs low is important for any investment, but to a greater degree for bonds.

The less obvious but more important advantage: With lower costs, the same level of expected return can be achieved for less risk. Framed differently, higher-cost managers will feel compelled to take on greater risk to deliver higher returns above fees. This can be particularly dangerous in a volatile market environment.

On the other hand, skilled, low-cost active managers can be both prudent and opportunistic during times of turbulence, acting on only the most attractive investments and passing on those that carry undue risk. In other words, they take on only smart risk, with no need to compensate for a higher expense ratio.

In my nearly three decades in the investment business, only a few themes have stood the test of time. One of them: Every downturn, disruption, or period of uncertainty has also unlocked opportunities.