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Franklin Templeton Insights: The First (and Worst!) Quarter is Over

In the first quarter of 2020, stock markets across the globe experienced one of the worst quarters in the history of global financial markets. But maybe it’s time for investors to take a pause and do some strategic thinking, according to Franklin Templeton Multi-Asset Solutions’ Wylie Tollette and Gene Podkaminer. They offer some practical investment wisdom in these turbulent times.

In some ways, the world fundamentally changed in the first quarter of 2020. March alone has shown how long-term market trends can change literally overnight. And yet, we still confront familiar tradeoffs as we turn to rebalancing and positioning our portfolios for an uncertain future. In between trying to figure out how to adapt personally and professionally to the rapidly changing COVID-19 pandemic, virtually all investors, individual and institutional, are about to confront a challenging set of decisions.

What should you do, and when should you do it? This brief list is intended to help provide investors of all types a framework to address these questions.

1. First, take a deep breath

We have experienced the fastest decline from record stock market levels to a bear market in recorded history, faster even than the 1929 crash that started the Great Depression (see chart below). Markets appear to incorporate new information more quickly these days but are still prone to over- and under-reaction, particularly when faced with an uncertainty like the coronavirus. It is virtually impossible to predict the exact peak or trough, or the behavior of market participants over the short-term; nor is that likely a worthwhile endeavour.

It is understandable that investors feel like their heads are spinning. Step back from that Bloomberg terminal or TV screen, take a deep breath, and try to picture the long view. Many of us have experienced severe market corrections before. And we’ve successfully navigated our way through them, one way or another. We will see our way through this challenging time as well. Red numbers eventually turn green.
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2. Take the long view

This may be a cliché in the investment industry, “that is what they always say after a terrible quarter”, but we believe taking a long-term view is truly essential in framing the asset allocation decisions ahead and positioning a portfolio for success. The asset allocation choices underpinning our portfolios are themselves based on long-term assumptions. The reptilian portions of our brains have evolved to react quickly and instinctually to immediate threats, so called “fast thinking.” Taking the long view is particularly important in the middle of a global virus pandemic, which likely activates our flight-or-fight response where reptilian thought processes can alter our usual investment decision making process. Focusing on 3-, 5-, and 10-year performance can help engage “slow thinking” and facilitate more rational decision making.

3. Think risk first

As investors, we cannot control returns, simply recall the last 6 weeks. But, we can control the risks we take (for the most part) in each part of our portfolios. Returns are essentially the “result set” of those risks. Many investors don’t fully understand their actual risk capacity until tested, as it likely was in the last six weeks.

We’ve just come out of a decade where central banks dampened volatility through unconventional monetary policy, so the recent spate of volatility has felt particularly shocking. Better to reconfirm your tolerance and capacity for volatility and align your forward-looking asset allocation with that (now better understood) risk capacity. The alternative is to bumble ahead in relative ignorance. It is better to make an explicit set of decisions than to implicitly lurch ahead.

One bright spot: viewed from a valuation perspective (the way Benjamin Graham thought about investing), the typical portfolio is actually lower risk now than that same portfolio was six weeks ago. It probably doesn’t feel that way – more like you might be holding a grenade, but one shouldn’t focus on feelings when it comes to investing (see “fast” vs. “slow” thinking noted above).

4. Rebalance thoughtfully

Recent market performance is exactly the type of event where a disciplined policy of rebalancing back to strategic targets thrives. You are not going to get the timing exactly right (see above on calling peaks and troughs). But rebalancing is part of strategic asset allocation, and it is usually built on capital market expectations that look out 7, 10, 25 years or longer. So should your calculus of whether your approach to rebalancing is successful. We recommend starting to average your way back to target ranges over the next few months as the outlook becomes clearer, rather than a “big bang” approach of returning precisely to targets.

Even if you were ill-prepared for the recent downturn, say, for example, by having failed to rebalance out of equities as they rallied through the end of 2019, most investors have the time horizon to focus on the 3-, 5- and 10-year returns. And, those are generally the numbers that really matter anyway.

5. Have more liquidity than you think you might need

While the current crisis looks different from 2008, some things stay the same: there’s no substitute for liquidity. When markets are melting down, few things are as handy to have on hand as cash and other truly liquid assets. Even gold, the stereotypical “safe-haven” asset for nervous savers and investors, was negatively impacted; in other words, “cash is king.” In the event investors with near-term liabilities decide to allocate a year or two of projected cash demands in cash and short-term sovereign bonds, this may allow a portfolio to avoid selling long-term assets in the short term when markets remain volatile.

6. The denominator can dominate

As at the quarter-end, investors with significant illiquid or private holdings will soon find that their public market assets have dramatically re-valued. Meanwhile, private holdings, which tend to rely on appraisal-based valuation on a quarter or more “lag”, are still sitting pretty (if stale) with 31 December 2019 market values. This will likely make the illiquid asset classes in a portfolio look larger than they truly are, as the values are surely impacted by recent market turmoil but accurate prices are not immediately observable.

Whether a parcel of real estate (for example) is owned by a REIT (valued daily) or owned by a limited partnership (valued quarterly), the actual underlying property’s true economic value should be similarly impacted. This phenomenon can make calculating allowable asset class ranges challenging, due to the unknown “total assets” denominator. A simple solution for allocators to address quarter-end rebalancing is to estimate the mark-down and include this in both the numerator and denominator.

7. Capital calls are coming

Private assets are invested based on the manager’s timing, not the investor’s. Once an investor commits capital, it may not be drawn down for years. In the current market, smart private asset managers are going to be seeking bargains and are likely to call capital, most likely, at the worst time for allocators. For a typical retail investor, a corollary exists in the form of unexpected expenses or loss of employment, difficult to predict and potentially very impactful. These types of events need to be built into your potential liability projections and rebalancing approach – another good reason to follow tip #5 above.

8. Don’t sell long-term assets in the short term

This sounds basic, but it is remarkably common, even among sophisticated investors. Following the global financial crisis, one large US institutional pension fund, for example, found its portfolio dramatically outside of its asset class ranges. In anticipation of receiving capital calls from its private equity and real estate managers, public equities were sold near the bottom of the market in 2008–2009 to raise cash. As stock markets recovered over the following several years, it missed out on the rally on those same equity assets. Similarly, some of the more levered real estate projects were taken back by banks at the depths of the crisis and its real estate portfolio is still healing, more than 10 years later.

Unrealised gains and losses are just that – unrealised. Selling long-term assets with positive forward prospects at transitory low prices violates the first truism of investing: “buy low, sell high”. See tip number 5 above about maintaining a little bit more liquidity than you think you might need, just in case.

9. Diversify

Recently, it has been very difficult to beat a “boring” 60/40 portfolio of the MSCI All-Country World Index (ACWI)  / Bloomberg Barclays Global Aggregate Bond Index (see chart below). There are two related reasons: 1) the performance of fixed income; and 2) the risk diversification from the relatively large 40% allocation to bonds during equity market drawdowns. Much of fixed income performance has been due to the behaviour of long-term rates for the past 35 years – they have steadily gone down, increasing the value of long-term bonds and also providing much-needed diversification against equity factors. As sovereign bond rates approach zero: already near or below zero in much of the developed world, investors will need to look further and harder to diversify equity risk.

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Finally, we expect markets to continue to be volatile until there is a clear path for both humans, economies and capital markets to navigate the pandemic. Tip #10 is to go back to #1 and read the list from the top, beginning with another deep breath. Keep calm and carry on.


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