How are chief investment officers balancing upside participation with downside protection ahead of what they see as a likely stock-market correction? State Street Global Advisors set out to find out in a new white paper titled Walking the Tightrope. Among the findings: CIOs are concerned about potential market shocks, but they remain heavily invested in equities. State Street investigates why and looks at ways of addressing challenges CIOs face in implementing downside protection in their portfolios.
Potential Market Shocks
State Street asked CIOs what factors would be the largest contributors to a potential market drawdown, and they provided nine distinct answers:
- Rising geopolitical risk (43%)
- Slowing growth in emerging markets (41%)
- Global economy slips back into recession (38%)
- Significant fall in oil prices (33%)
- Disappointing corporate earnings (33%)
- Deflationary pressures in the Eurozone (27%)
- Ongoing concerns about high unemployment (21%)
- Tightening by central banks (20%)
- Spread of Ebola or other pandemic risk (9%)
And yet, even with a majority of CIOs foreseeing a likely stock-market correction, they remain invested in equities. Why?
The Lure of Equities
The majority of CIOs surveyed said they expected a stock-market correction sometime in the next 12 months, and 53% said they would like to reduce their allocations to equities. However, due to the low-interest rate environment, yield-starved investors don’t seem to think they have more attractive options: 63% increased their developed-market equity holdings over the past six months, and nearly half increased their emerging-market holdings, too.
Among CIOs who said they had increased their equity holdings in the past six months, the following reasons were cited:
- Pressure to meet funding requirements (64%)
- Pressure to meet objectives (58%)
- Equity markets continue to offer good value (55%)
- Lack of opportunities to earn a return with other asset classes (47%)
- Market movements have increased allocation without action by the investor (23%)
With more upside participation, ahead of a possible correction, CIOs should be looking for more downside protection. State Street worries that CIOs may be overconfident.
Ninety-one percent of CIOs surveyed said they were confident in their portfolios’ ability to weather a “major market correction,” and 41% have made no changes to their downside protection plans, despite the recent volatility. State Street hypothesizes that this is because investors have profited from buying on recent market dips, and they may think this is a viable strategy going forward. Strong broad-market performance over the past 18 months may explain the somewhat negative view of downside protection, but State Street openly wonders if CIOs are self-assured or overconfident.
CIOs are using too few downside protection strategies, in State Street’s assessment. Sixty-five percent said that diversification alone is enough to protect their portfolios, which suggests that they’re unaware of the risks posed by equity concentration in their holdings. Fifty-three percent use dynamic allocation for downside protection, which is good, but State Street says that diversification and dynamic allocation aren’t enough.
When asked to name the biggest barrier to adding downside protection, timing and high costs were the most popular answers, with 18% apiece. Sixteen percent were turned off by the regulatory restrictions surrounding downside protection strategies, while 10% said the available strategies were too complex. Six percent cited past dissatisfaction with downside protection.
Fifty-four percent of CIOs said “timing the implementation” of downside protection was the biggest implementation challenge, followed by “adjusting the strategies in response to the changing market environment” at 35%, and “gaining the knowledge and confidence to feel comfortable with the tools” at 33%.
In response, State Street says more education is necessary. For example, not all downside protection strategies have the high costs typically associated with option-related strategies; and many strategies are not as complex as they might at first seem. Communication is difficult, but essential, according to State Street.
For more information, download a pdf copy of the white paper.