«Good returns are not down to lucky forecasts. Rather, they are the result of careful risk management.»
(Jacques E. Stauffer, CEO, PARSUMO Capital AG)
Investors had a very difficult year in 2018, with almost all traditional asset classes and markets finishing the year with negative returns. The portfolio results were spoiled by December in particular, when significant losses were recorded across the board.
PARSUMO was able to limit the damage, thanks to its prospective risk management. To protect our portfolios against substantial setbacks, we have been slightly underweight in real assets since November 2018 and significantly underweight since mid-December. The massive corrections on the real asset markets were efficiently cushioned with an extremely low risk budget. Since then, the equity exposure of our portfolios has been the lowest ever held by PARSUMO. Our proprietary risk indicators and Risk Regime Investing were again on target, and our client assets are largely protected against price losses.
The extent of the losses in the different asset classes was considerable, with capital preservation possible only with fixed-income investments in Swiss francs and foreign currencies:
|Asset class||Index||Return |
as of 31.12.2018
in base currency
as of 31.12.2018
in base currency
|Equities World||MSCI World Net USD||-13,42%||-8,71%|
|Equities Switzerland||Swiss Performance Index||-9,05%||-8,57%|
|Equities EM||MSCI Emerging Markets NR USD||-7,47%||-14,58%|
|Bonds World||JPM GBI Global Traded TR USD||2,01%||-0,66%|
|Bonds Switzerland||Swiss Bond Index AAA-BBB TR||1,42%||0,07%|
|Commodities||Thomson Reuters/Jefferies CRB TR USD||-12,46%||-10,66%|
|Real Estate Switzerland||SXI Real Estate® Fnds Broad TR||-0,99%||-5,32%|
|Real Estate World||FTSE EPRA/NAREIT Global TR USD||-4,79%||-5,55%|
|Exchange rate EUR/CHF||-1,20%||-3,72%|
|Exchange rate USD/CHF||-0,05%||0,73%|
The table also shows that the last quarter of the year had devastating consequences. On the basis of our risk indicators, we had an underweight position in real assets in the portfolios during these three months – particularly in December – and were thus able to cushion the blow. In contrast, foreign currencies made only a very minor contribution to the full-year result – the dollar to the slight advantage of Swiss franc portfolios, the euro to the detriment.
Should we expect more turbulence this year? When should we dare venture into the markets again?
It takes time to identify far-reaching problems
We believe that prospective risk management is necessary. In the current situation, every loss avoided represents an opportunity to restart from a comparatively higher portfolio value.
The stock markets have long watched the counterproductive behavior of various political players. However, a clear concentration of risks has been observed in the past two months, with investors focusing on a few, decisive risk areas. Our daily calculations of the risk indicators and the associated preparation for the seemingly improbable enable effective and timely measures to be taken to protect the portfolios. Which problem areas have come to the attention of investors in recent weeks?
On the one hand, we have the trade war; on the other, we are seeing mixed signals from the fixed-income securities market. Despite interest rate hikes by the Federal Reserve, longer-term interest rates are falling in the US. The Fed’s inflation targets are being narrowly met, and overheating of the economy is not an issue. The bond market is sending clear signals, prompting investors to reposition themselves. We do not believe the trade dispute will develop into a long-standing conflict. However, the majority of investors do not share this opinion. They and the stock markets have now made it clear that they are no longer prepared to participate in this behavior. It’s hard to predict exactly how long the investment strike will last.
This also raises the question of what risks we might face after an accentuated, perhaps even exaggerated, correction. The opportunity costs can build up just as quickly as the setbacks before them.
Our indicators have already proved themselves many times in such situations. In November and December, for example, they gave us a clear and reliable signal to withdraw. We are confident that they will also tell us the right time to re-enter.
How should investors behave?
The altered risk conditions on the capital markets have prompted us to reduce our real asset ratio in three stages. The markets are extremely tense and fragile. The old saying «never catch a falling knife» is very apt in this environment. In other words, investors should not buy equities that are on a downward trend – this is a rule that we, as risk managers, have made our motto. In particular when conditions change as quickly and emphatically as at present, seeking short-term gain is not justifiable.
In our newsletter in October 2018, we wrote:
Although valuations in the US have declined slightly, we are standing by our assessment that the American market is overpriced and that there are some good options. We still favor emerging markets, some of which have suffered significant corrections, as well as the more favorably valued European and fast-growing Asian markets.
We continue to stand by this assessment. Since the beginning of October, Switzerland (-9.05%), Europe (-12.88%) and the emerging markets (-7.47%) have suffered lower losses than the Nasdaq (-16.84%) and the broad overseas market (-14.50%).
The distinction between large caps and small and mid caps also appears important to us. The market has punished small and medium-sized companies more than others in recent months. In Switzerland, the SMIM lost 19.94%, while small caps were down 17.73% worldwide and 18.89% in the US. We have identified some exaggerations there that could be seen as opportunities. However, before we commit to these, we must see a more constructive risk environment.
«A rules-based approach prevents wrong decisions based on emotion.»
(Marcel Burger, Managing Partner, PARSUMO Capital AG)
Findings from Risk Regime Investing (RRI)
We also did not expect the markets’ negative development to be so severe and quick. However, our rules-based strategy and indicators spurred us into action.
At the beginning of October 2018, our risk indicators gave us the first clear signal to neutralize our portfolios. A further signal in mid-November prompted us to switch to an underweight position. Halfway through December, our indicators told us that the portfolios should be in protection mode. Since then, our client portfolios have been largely shielded against additional losses – and for good reason, as further setbacks are expected.
The markets are very fragile at present, and are even falling in response to existing negative news. Although positive news provides a brief impetus, a return to the negative underlying trend follows almost immediately. To improve the mood among investors, the US Federal Reserve would have to significantly loosen its restrictive policy, and the trade dispute between the US and China would have to be miraculously resolved.
Although the latter is certainly possible – both parties are increasingly feeling the effects of the market turbulence and are unlikely to be keen on an escalation – investors do not seem to think the equity markets are easing. In fact, quite the opposite. It’s highly unlikely the Fed will loosen its restrictive policy, as a normalization of monetary policy looks essential in order for it to be prepared for the next crisis.
The development of our risk indicators Systemic Risk Index and Turbulence Index suggests a sustained and far-reaching reorientation of investors. It usually takes time for such developments to calm down. Only then is an increase in the weighting of real assets recommended.
Findings from Quantitative Stock Selection (QSS)
Our defensive style weighting has proved its worth over the past few months. Despite the extremely difficult months of November and December, when erratic developments were seen in certain equity markets, we finished 2018 with a positive alpha in three out of four QSS portfolios.
In our last investment update, we wrote:
After a prolonged recovery phase and the subsequent boom, the economic cycle now appears to have entered a phase of weakening. It remains to be seen whether this slowdown will lead to a recession, or whether the economy is just cooling down temporarily before gathering pace again.
This question is now more relevant than ever, and it has not yet been answered conclusively. At least the markets appear to have high respect for the imminent economic developments. We believe that much of this potential negative development has already been anticipated in the prices. However, fragility is making the markets very prone to exaggeration, including down.
Our QSS flagship, the PARemerging Markets Equities Fund, generated a positive active return in nine out of 12 months in 2018. In our European portfolio (PAReurope), we achieved a positive alpha in 10 out of 12 months. However, our PARglobal Small Cap portfolio has also outperformed the benchmark in four out of six months since its launch in mid-2018. Only the PARswiss portfolio recorded a negative result against the benchmark (-1.3%).
These results confirm that due to its methodology, the QSS approach is sustainable and allows absorption of the style premiums. The neutral weightings across sectors, countries and currencies also reduce the tracking error, and the selected securities with advantageous benchmarks decrease the portfolio’s risk in relation to the benchmark.
Our careful, in-depth factor and style analysis gives us great confidence in selection of the best factors and styles for the current market conditions. Thus, we can ensure that the QSS approach continues to achieve good results in future.
Global financial markets – review
The international equity markets have had a very tough year, with all leading indices suffering significant losses. The negative league table is led by the Chinese CSI 300 Index with -26.33%, followed by Germany’s benchmark DAX index with -18.10%, the UK’s FTSE 100 with -12.48% and the Japanese Nikkei with -12.06% (all in base currency terms). The SPI was down by a comparatively moderate 8.57%, while on the US equity markets the S&P 500 (-6.24%) and the Nasdaq (-1.04%) performed relatively well. The MSCI World equity index saw a correction of 8.71% in 2018, and the MSCI Emerging Markets index suffered a slump of 14.58%. Swiss franc investors made a slight currency gain on dollar-denominated investments, but European securities were associated with FX losses.
In 2018, investment grade bonds were the only asset class able to keep its head at least slightly above water. JP Morgan’s global market index advanced by 0.66%, representing growth of 0.49% in franc terms. Franc-denominated bonds with ratings between BBB and AAA hardly moved either, ending the year with a slight gain of 0.7%. The yield differential between short and long-term bonds has remained virtually unchanged over the last 12 months.
Commodity prices fluctuated heavily for long periods last year. The precious metals segment lost considerable ground, but energy (driven by the oil price) again performed well. At the end of September, commodities had achieved a respectable overall return of 8%. This development saw a sharp turnaround in the fourth quarter, with commodities hit hard and crude oil prices plummeting by more than 40% from early October to the end of December. Gold, on the other hand, benefited from its status as a safe haven in turbulent times. At the end of December, the broad-based CRB commodity index was down -10.66% year-to-date in dollar terms.
In 2018, the US Federal Reserve continued its trend of raising key interest rates quarterly. In Europe and Switzerland, there is still no end in sight to the ultra-loose monetary policy of recent years. Interest rates in Switzerland and Europe are likely to remain very low for the foreseeable future, not least because of the global trade disputes, which are also affecting export-strong Germany. In 2018, Swiss real estate funds posted losses of 5.32%, while foreign real estate investment was down 5.55% (-4.79% in franc terms), due primarily to a severe loss of confidence in the fourth quarter.
In the first quarter of 2018, the euro was the winner and the dollar the loser among the major currencies. This development saw a sharp turnaround in the second quarter, with the dollar gaining considerable ground against the franc and the euro. The difference in interest rate movements between the US and the rest of the world also stabilized the dollar against most currencies in the second half of the year. Over the year as a whole, the dollar gained 0.73% against the franc. The persistent weakness of the euro resulted in the single currency losing 4.39% against the dollar. At the end of December, it was also down 3.72% against the Swiss franc.