Brexit: A Case Study in Diversification and Downside Protection
You probably know by now that Britain has voted to exit the European Union. We won’t offer detailed commentary on the political situation, but those who are interested can watch Prime Minister David Cameron’s resignation speech here, and see a Globe and Mail situation brief here.
The ‘Leave’ outcome was mostly unexpected, as polls run earlier in the week had shown the ‘Remain’ camp to be confidently in control. As a result, stock markets around the world reacted predictably to heightened uncertainty and potential hidden risks on bank balance sheets.
Interestingly, while naively optimistic stock investors were caught flat footed, global government bond markets had been signaling that a British exit was a real possibility for most of the year. To wit, government bonds in Japan, Germany, and the United States – the world’s perceived ‘safe havens’ – have been hitting fresh all-time lows in yields over the past few weeks. Since falling yields mean higher prices, this behavior suggests that many large and well informed institutions have been seeking safety, pushing these bond prices to all-time highs. Gold – another traditional safe-haven asset – has also been quietly outperforming.
Recall that the investment methodology we employ for the ReSolve Adaptive Asset Allocation strategy systematically tracks the capital deployment patterns of global investors, which manifest as relative price trends. We also seek to maximize diversification and balance risks across asset classes, as this is the only reliable shield against the sort of shocks markets are experiencing this morning. As such, U.S. Treasury bonds have been our largest holdings in portfolios for most of 2016. Today they closed very near to new all time highs. Our gold position also paid off, to the tune of about 5%.
The balance of strategy assets are in U.S. traded real estate, and U.S. and Canadian stock markets, largely insulated from the direct economic fall-out in Europe and the U.K. In fact, the only position that the strategy held with material direct exposure to Europe is an international real-estate ETF, and this represents just 8% of the portfolio. Even better, European assets are less than 1/3 of the holdings of this fund, so the true exposure is less than 3%. The following table delineates the geographic exposure of RWX, our international REIT holding.
Source: State Street
As a result of our large positions in safe-haven assets and extreme level of portfolio diversification, we expected today’s volatility to have a minimal impact on the strategy. We were confident in this benign outcome because we quantify each day how risks are balanced in the portfolio, and because we have experienced these sorts of days in the past. For example, we estimated coming into today that ‘safe haven’ and ‘risky’ assets comprised about equal portions of the fund’s portfolio after accounting for correlations (see donut chart of risk contributions below).
ReSolve Adaptive Asset Allocation Fund | Estimated Proportional Risk Contributions for June 24, 2016
Source: ReSolve Asset management. Data from CSI.
You may recall a similar type of morning in August last year, when stock markets around the world opened down 5-10% after stocks plunged overnight in Shanghai. On the same day, safe-haven bonds and gold jumped commensurately. But, as you can see in the chart below, the Fund portfolio was like the eye in the middle of a hurricane. Notice how assets in the portfolio surged higher or lower while the actual portfolio (thicker dark blue line) holding those assets in diversified weights was flat as a pancake.
Source: ReSolve Asset Management. Data from Reuters.
We waited to publish this until after markets closed today so that we can present the same chart using today’s returns. Unsurprisingly, we have observed the same quality of result. That is, by dynamically adjusting portfolios to bias toward higher momentum global assets, and emphasizing exposures to assets with strong diversification properties, the strategy is resilient to these types of shocks. The following chart also highlights portfolio weights in brackets next to asset class names.
Source: ReSolve Asset Management. Data from Yahoo Finance.
We’ve said it before, and we’ll say it again: our top priority is protection of capital. During uncertain times like we have today, that means taking cautionary market signals seriously, and consistently prioritizing diversification. Remember, our dollars are invested in the strategy too, so we are unequivocally on this journey together.