While some events can be anticipated, other implausible ‘black swan’ events can often have catastrophic consequences, according to the Fidelity Multi Asset team.
Events such as the 2011 Japanese tsunami or 11 September terror attacks of 2001 can often have a significant impact on markets.
As such, it can often prove challenging for investors to protect against them, but they can take some steps towards building more robust portfolios.
This can often mean diversifying sources of risk within a portfolio and holding hedging instruments, although the costs of such insurance can add up.
“For most people, it makes sense to stay invested most of the time, which means taking reasonable risks while being mindful of potential market shocks,” the team noted.
“It's impossible to completely avoid drawdowns when investing, but thoughtful portfolio construction and contingency planning can still reduce the impact of large sell-offs.”
Yet, there are certain lessons that investors can learn from previous events.
“History has shown that highly improbable events happen more often than expected, so investors should look closely at tail risks that seriously damage their portfolios,” Fidelity noted.
One such example are concerns that a large country could leave the eurozone – “which could sound the death knell for the euro”.
This has already been seen in market sell-off in May 2018 during the Italian elections, which eventually returned a coalition government of two populist Eurosceptic parties.
Performance of indices during H1
Source: FE Analytics
“Although the election was in the diary, the subsequent flight to safety among global investors showed fears of further disunity among eurozone nations,” they noted. “Investors try to assess what could go wrong, quantify how likely the event is, and think about the possible implications if it happens.”
Investors should also bear in mind that quantitative models are unlikely to identify ‘black swan’ risks, as they rely on historical data and such events “by definition have no precedent”.
Additionally, previous events have shown that markets are increasingly interlinked and assets may suddenly become highly correlated.
Yet, investors can study a market’s key drivers and how they change over time to understand how they react to a real adverse, high-impact event.
“Before the Brexit vote, like many investors, our base case was for the UK to vote to remain in the EU,” the team highlighted.
“We ran scenario analyses to evaluate our exposure to Europe and how metrics such as volatility, profit & loss and value-at-risk looked under different outcomes.
“Although the outcome of the vote was surprising, our simulations helped to ensure that we were not overexposed. Uncertainty remains as to what form the actual event will take, so the scenario planning continues.”
Performance of FTSE All Share since EU referendum
Source: FE Analytics
Other qualitative factors can also affect returns – such as the threat of a Korean peninsular war – although markets have grown numb to that threat, “a sudden attack without warning would be surprising and highly impactful”.
“Experience suggests that Korean equities would sell off aggressively, as would other emerging market assets in Asia, while the dollar and Treasuries would rally,” they added. “By simulating this market reaction, it’s possible to plan a response ahead of time.”
Furthermore, the Fidelity Multi Asset team note that markets tend to become less liquid during times of high uncertainty and tail-risk events, “raising counterparty and liquidity risks”.
“The operational and financial stability of all potential counterparties needs to be assessed and this exercise is repeated as market events unfold,” they said.
“Analysing the liquidity of holdings and portfolios under stress-test scenarios can help investors anticipate and minimize issues when redeeming the assets.”
While noting that it is impossible to position for every event and that hedging can be costly, there are also opportunity costs, particularly if you position for a specific outcome rather than a range of possible market moves.
“Not having all your eggs in one basket is also a big part of mitigating tail risks,” said the strategists. “Increasingly, it’s important to identify assets that have a negative correlation with other holdings as well as being attractively valued.”
Investors can refer to a more recent and painful lesson, following February’s market sell-off.
“In recent years, one of the most popular trades has been retail investors taking short exposure to the VIX using exchange-traded products, which has kept downward pressure on volatility,” they said.
“Investors perceived the low volatility as supportive of equity markets, which ultimately fed a positive feedback loop.”
As such, Fidelity Multi Asset managers sold out of US stocks at the start of the year when they hit record highs over fears that volatility was unusually low and could normalise in a random shock event.
“This event occurred in February, when higher wage inflation data caused the VIX index to spike,” the noted.
“That triggered a negative chain reaction in stocks, as the short VIX vehicles had to sell US equity futures to rebalance their portfolios.”
Performance of VIX over 1yr
Source: FE Analytics
Another issue that investors should take note of is the opportunities that can arise in the wake of a ‘black swan’ event.
“Fundamentals drive long-run market returns but are not always reflected in market prices,” they explained. “Some of the best opportunities arise in the aftermath of a large market sell-off.
“Through detailed research, thoughtful portfolio construction and a range of monitoring tools, investors can be better prepared for changes in market dynamics and high-impact, tail-risk events.”
The Fidelity strategists said investors should combine quantitative models with market participants’ experience and insights.
Investors should also account for the changing nature of correlations between asset classes to diversify and manage the risk of contagion, they highlighted, and the return-eroding nature of hedging instruments.
They concluded: “By considering potential black swans, investors can better understand their vulnerabilities and incorporate mitigation measures or plan responses. What are the extreme scenarios no one expects? A good question to bear in mind.”