In this time of increasing turbulence, how can investors learn from the lessons of the past and be prepared for any further chaos? Absolute return funds offer one way to adopt a defensive stance
The period of stable interest rates, declining inflation and above-trend economic growth, which has reigned in most of the industrialised world for nearly two decades, was given a name in 2004 by Ben Bernanke, the current chairman of the Federal Reserve. He called it 'The Great Moderation'.
In the financial markets, it seemed that periodic crises - such as the Mexican default of 1994/5, the LTCM failure of 1998, the Nasdaq bubble and its aftermath, and the 11 September terrorist attacks - had been overcome, after interventions from central banks, without undue damage to the real economy.
By early 2007, it seemed that this message had also been taken on board by financial-market participants. The VIX index, which measures the level of implied volatility in options prices that is very often used as a proxy for the 'fear factor' in equity markets, had declined steadily to historical lows of around 10%. This suggested that investors had accepted the argument of a long-term downward shift in risk.
A whole host of reasons have been given to explain this apparent decline in macroeconomic volatility - improvements in central banking, better regulation, the end of the Cold War, financial market innovation and demographic shifts - to name a few.
Those of a more sceptical bent might point out that government officials and leading academics have made similar claims before. Just before the Wall Street Crash of 1929, the noted Yale professor of economics, Irving Fisher, stated: "Stock prices have reached what looks like a permanently high plateau."
In the 1960s, credit for a decade of expansion was claimed by the 'new economists', who had reputedly mastered the fine-tuning of the system through fiscal and monetary interventions. This was, of course, just before a dramatic rise in inflation, the two oil recessions and the exchange-rate instability that characterised the 1970s.
From 1999 to 2000, Alan Greenspan started to talk of a 'productivity miracle' in the economy, which in turn could be used to justify the inflated level of equity prices. The bear market of 2000 to 2002 followed immediately after.
Of course, it is easy to be wise after the event, and these quotes should be seen only as an example of the inaccuracy of forecasting (and of the human capacity for rationalising when faced with extreme levels in markets).
Nevertheless, the continuing talk of a 'Great Moderation' (this phrase has appeared in the titles of several recent research papers from the Federal Reserve Bank and the BIS in Switzerland) should not lull us into complacency. Indeed, the graph of the VIX index for 2007 (right) shows a rise in the 'fear gauge' from the depressed levels that have prevailed for the past four or five years. From around 10% at the beginning of the year, the VIX has risen to the high teens, with a spike over the summer as concerns over a possible seizing up of the credit market became widespread.
Although equity markets worldwide fell sharply in July and August, they have since recovered most, if not all of their losses, and some emerging markets (notably China) have seen dramatic rises to all-time highs. This has been mirrored in a fall-back by the VIX index during September and October to date.
So how should investors react if they are concerned about a possible return to market turbulence?
How to react to turbulence
One way to help protect a portfolio invested primarily in equities is to buy put options on equity indices or individual stocks. This works as an insurance policy with a fixed cost, and has the added benefit of being cheaper when VIX levels are low (which they are, still, on a historical basis). This is because the level of the VIX feeds directly into the price of the option - the higher it is, the more expensive the cost of the insurance.
Another option is to move a portion of the portfolio into absolute return funds, which, as their name suggests, are designed to produce positive returns in differing market conditions.
The absolute return fund sector comprises a large number of quite different strategies, some of which have typically done better than others at protecting capital during periods of equity market declines. The strategies that may not provide such good protection in times of turbulence are those that tend to have net long exposure (where the total long positions outweigh the shorts), or those that are sensitive to rises in market volatility (the VIX index) - this is true for a number of absolute return fund categories.
By contrast, equity market-neutral funds are designed to match their long and short positions so as to have little net exposure, and such funds have historically been much more reliable performers when equities have fallen.
Whether or not the rise in the VIX index in 2007 is the start of a trend, presaging a return to more turbulent times, remains to be seen. But, by contrast with previous decades, those investors who wish to adopt a more protective stance now have a number of absolute return funds at their disposal, which can help protect capital and reduce portfolio volatility. As always, due diligence on the underlying fund strategies is essential.