Market volatility is back. Anthony Okolie speaks with Anna Castro, Senior Portfolio Manager, TD Asset Management, about how to make the volatility work for your portfolio and the importance of going beyond traditional strategies for diversification.
- Anna, volatility is back in the markets. You brought with us an 18-month fixed chart. Tell us what's happening here.
- So, hi, Tony. So the VIX is an indicator of investor sentiment on the expected short-term volatility. And as you can see from this chart, in 2019, it hovered around in the teens, so there wasn't really much volatility until about February this year, when it spiked in March, all the way up to historic highs, close to 90, mainly because of the pandemic worries, economies locked down, as well as an oil price war.
Since then volatility has fallen. It even touched the low 20s a few weeks ago. Because the central banks and government leaders have been very committed, very decisive, with unprecedented level of stimulus, providing confidence that they are willing to support economies and improve the liquidity conditions in the market.
About a few weeks ago, you had a pickup in volatility again, because there's now questions about the pace and level of the recovery and whether or not as economies open, will there be another surge of the virus in various countries. And you also have a situation where geopolitical risks are picking up.
So while compared to how it was in March, volatility levels have dropped. It's still much higher here than where it was in the past. And we expect these volatile conditions to persist.
- So how does this heightened volatility, how does it impact your investment strategy?
- So in this volatile market, with such changing conditions, it really, really highlights the importance of diversification. And this is something our Asset Allocation Team really focuses on, both on the traditional sources of diversification and non-traditional sources. And I'll explain why that's important.
Traditional sources of diversification, an example of that would be having a mix of different types of characteristics of securities, sources of their cash flow. Another way is to change the mix of equity and fixed income in the portfolio. The assumption there is that fixed incomes, specifically government bonds, are expected to provide as much downside or protection or stability when the equity markets sell off.
And it's important to go beyond these traditional strategies because of where we are right now. Right now, bond yields are very low, and governments are stimulating. And that's actually a challenging environment for fixed income, specifically government bonds. So they may not provide as much of an offset in stability in the future if the equity market sells off, and that's why it's also important to have non-traditional sources of diversification, such as options in a portfolio.
- So why options?
- Well, options in general, the value of the options appreciate as volatility increases. And in our Asset Allocation Team, we would incorporate a variety of options strategies to enhance diversification in the portfolio. Options allow us to manage risks, increase the resilience of our portfolio, and also allow us to be very nimble in picking advanced opportunities.
- So what options strategies might be appropriate for these markets?
- So there's a couple of options strategies that we could incorporate in the portfolio, and I could give you some examples. One would be to use options to reduce downside during a market sell-off. So if our team was concerned about a weakness or a material weakness in equity markets, we would have more put options in the portfolio. And these put options appreciate in value and provide that portfolio insurance, that level of stability, when the market sells off.
Another way we could use options is generate income against cash while also monetizing the volatile environment and implementing a view. Let me give an example of that as well.
So one of the things that our team has done is really monitor some of the data once the economies have opened. So we were looking at some mobility data. We could also see how customers felt confident about the support of the government, as well as their willingness to go out. They've been going to shops, driving around, even buying cars.
So we believe that we would like to add some companies that are exposed to this, such as retailers, home builders, home improvement retailers, autos, and transport, as these companies would appreciate in value. Their stock prices would appreciate in value as the economies continue to open and activities are starting to increase.
And one way we did that, we could do that, was selling puts against our cash to generate a premium, earn some income against that cash, and have the ability to acquire these companies at a lower price. So that's an example of a way where we take advantage of a volatile environment to earn some incremental income against our cash and also be opportunistic in adding those securities because of our research view.
- And as you've highlighted, these are very uncertain times. We've seen big moves in the markets. Certainly, the markets have recovered remarkably, but we could still see some big moves to the downside. With that in mind, what's one thing you'd like to leave your viewers with today?
- So yes. You've pointed out that we believe that volatility will continue this fall, as how the changing environment. That's why it's very, very important to have a broad set of source of diversification, both traditional and non-traditional sources. And today I've spoken about how we're using options to enhance diversification in a nontraditional manner.
And this is a way for us to really improve resilience and ability of the portfolios to be nimble. What I do want to remind everyone is as they stay focused, it is possible for your portfolio to thrive in this volatile environment and continue to build wealth in the long-term.
- Anna, thank you very much for your insights.
- Thank you, Tony.