How should allocators respond?
Prepare stakeholders — Increased volatility often creates governance challenges. Anticipating this and sketching out a range of possible outcomes can help prepare stakeholders and avoid policy mistakes.
Retain diversification but stress-test correlation assumptions — While I would stick with traditional sources of diversification, they may be somewhat limited in their effectiveness — for example, stocks and bonds may continue to struggle at the same time when inflation concerns are paramount.
Seek “stability” in equities — With diversification in short supply, this may be a time to add potential sources of stability, and particularly within the equity allocation, which tends to be the largest driver of portfolio risk. Stability might be the third pillar in an equity portfolio, along with value and growth — a framework that could help boost portfolio resilience. There’s an adage that when growth is scarce, growth stocks outperform, and this was true for much of the last decade. Going forward, I believe, stability will be scarce and stable stocks are likely to outperform. In terms of specific types of strategies that fall into a “stability” bucket, low-volatility strategies may have a place, but it’s worth noting that they tend to be challenged in rising-rate environments. I would look to “compounders” (equity strategies focused on companies with high and stable free-cash-flow yield and the potential to grow modestly but steadily over time) and to defensive global equity strategies that seek to preserve capital in adverse markets while providing equity-like returns in up markets.
Think opportunistically and tactically — Volatile conditions often create market dislocations that opportunistic allocators can exploit by being providers of capital when it’s most in demand. Tactical asset allocation may also play a role, helping to tap into not just the big dislocations but also the smaller bumps along the way.
Consider hedging — This is about knowing your own risk tolerance and the point at which volatility would become uncomfortable and worth bearing some cost to hedge. Setting out a detailed hedging philosophy is key, recognizing that hedging comes at a cost and may not be suitable for many investors.
Figure out where hedge funds fit — The unconstrained nature of hedge funds means they can use many of the strategies I’ve discussed, including seeking stability at times, being opportunistic and/or tactical, and hedging risk.