Home / Analysis / To find their way through markets, investors need ‘optionality’

For the last decade, equities (repackaged and otherwise) have reigned supreme. But in a market where everything might soon start to break, investors have to be more nimble.

With rates rising and softer economic data rolling through, investors probably have “the best setup in the last decade” for a genuine cyclical bear market and earnings recession, says Michael McQueen, CIO of investment bond provider Foresters Financial and former CIO of Media Super. That could mean a 9-18 month period where the market “glides” lower – though it’s likely to feel more like a grind to the people in it.

“You don’t know which markets are going to be hit; you might have industrial companies hit quite quickly and refinance, reduce their cost base and trend sideways through the end of the bear market,” McQueen tells ISN. “You could have defensive stocks hold up very well right until the last third of that movement when they do violently reprice. You don’t know the contagion; you don’t know how it’s going to spread between companies and counterparties.”

Because they don’t know when things are going to break – and exactly what those things could be – investors need to get “optionality” back into their portfolios.

“If you’re in not just cash but liquid investments and are able to switch and reposition as the bear market rolls through, you’re going to be pretty well placed to navigate through that compared to somebody with a lot of money in alts, which are illiquid and have redemption windows, or a lot of money in real assets that take 90 days to liquidate.”

Optionality has been underrated of late, McQueen says. Into Covid and after it, equities and ‘repackaged’ equities – private equity and venture capital – reigned supreme, and there was limited reason to retain optionality in the portfolio. Investors prioritised diversification of growth drivers over diversification of defensive assets.

Liquidity is a big part of optionality, and it helps to stay in markets where assets are priced regularly and there are entities that are natural buyers; banks and insurers are always participating in the sovereign and investment grade fixed income markets, and a lot of securities are eligible for repo on central bank funding programs if things get particularly hairy.

“There’s not too much science; it’s more a state of mind,” McQueen says. “You’re not going to, based on a prediction about how markets might turn out, reduce your exposure to property and infrastructure trusts that you’ve held for a decade; but you might look to make sure you’ve got the plumbing set up to participate in the futures and options markets to take advantage of changes as they come.”

The Foresters investment team has been increasing the exposure to high grade credit and sovereign and semi-government fixed income and has bought gold as a diversifier in some of its portfolios; hedge funds have done well over the past 12-18 months (depending on the hedge fund and the strategy) but, given we could be about to see a violent drawdown or a cyclical bear market, there’s “hesitance” around how they might perform now.

“The setup looks quite constructive for hedge funds,” McQueen says. “But the regime may change. So we’re trying to do it in a considered fashion.”