Tactical Managers Must Avoid Volatility Traps to Capture Upside Potential for Investors

In a year characterized by unprecedented use of “unprecedented” to describe record-shattering market mania in both directions, financial markets are back to hovering around all-time highs from their March 2020 lows. However, the contentious U.S. Presidential election between President Donald Trump and former Vice President Joe Biden, is already creating market volatility, and the outcome on election night may lead to a more significant risk-off event in the weeks immediately following. That said, it’s no wonder that nervous advisors and their clients may be seeking a way to hedge or buffer downside on equity portfolios without sacrificing upside participation if the market instead rallies on the outcome.

It seems that investors have been willing to pay any price for forward earnings this year. Yet for tactical managers and strategies, market participation is the name of the game — unless you enjoy standing on the dock watching your friends sail away on a party yacht without you.

In my view, I say give me high priced stocks and fancy lattes, because low multiples and regular coffee are a thing of the past. Nevertheless, the market skimmed some froth off the top in September, dialing back roughly half of August’s gains and reminding us that indulgence must eventually take a pause. The S&P 500’s 3.80% loss tells less than half the story, as the index logged a full 10.5% correction within the month. The difference is in the bookends. Election uncertainty, fears of a slowing economic recovery, and Supreme Court headlines (implications for the ACA’s pending trial date) may have played a part, but word on the Street was SoftBank (and a large, rabid retail herd) helped bid up the August rally with record option buying leveraged to the growth/momentum/tech tailwind, which then was met by increased gamma hedging by banks on the other side of the trade. This dynamic may have largely contributed to the unwind throughout September. The weakness presented buying opportunity, as the strong tailwinds behind the attractiveness of today’s winners continue blowing. Despite the pullback, the forward P/E multiple on the S&P 500 stood firmly at 21.7x as of September 30, compared with 23.7x when the index set a new record high on September 2, and versus the 10-year average of 15.6x. The market is looking past the virus-induced earnings coma toward a happier future.

There are reasons to argue for continued market strength, including an economic recovery, pent-up demand, and more money in employees’ pockets by working from home. On the other hand, headwinds include permanent job losses, and coronavirus and election uncertainty making for nervous consumers and business investment.

Looking ahead, avoiding volatility traps will be key moving forward for tactical managers to improve their odds of capturing upside. Investment decisions based on a systematic plan are likely to yield better odds of success than decisions influenced by noise. A plan to manage downside risk should remove emotion from the equation.

With volatile markets likely here to stay for the near term, I believe that tactical strategies should be positioned for balance as growth/momentum and value/cyclicals continue their tug of war for factor supremacy. For enhanced risk management following our shift back into equities, we maintain a very small hedge. With tightly defined parameters for our hedging program, holding this small hedge serves the purpose of allowing for scaling up if market risks escalate during the remainder of our hedging window, which ends in the coming months.

Our different approach to tactical investing focuses on offense first and defense only for large, sustained market declines. Our approach also can use options to offset risks that are present in unstable market environments after periods of transition, such as the current election cycle. We are focused on selecting companies we believe are poised to thrive in today’s economy, benefitting from economic recovery and reopening, and the accelerated digital shift. As the market expects a step-up in volatility surrounding the election, we are positioned to buffer potential downside while maintaining full equity exposure to participate in the upside.