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Only Dead Fish Swim with the Stream

June 12, 2018 | Multi-Asset


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Over the past few years, we've witnessed a strong momentum-driven market that has pushed prices higher. This environment is challenging for fundamental investors because factors other than fundamental value are predominantly influencing prices.

One of those factors is rules-based investment strategies, which are driving asset prices up and concentrating those increases in specific sectors. However, that (market) free ride will come to an end, especially as central banks around the world start to unwind their ultra-easy monetary policies.

Rules-based investment strategies are driving asset prices up and concentrating those increases in specific sectors. However, that ‘free’ ride will come to an end.

In fact, so far this year, the market has a different feel to it. Market behavior in the past few years exhibited a sector-rotation strategy. As the market declined, those sectors declined even more. Then as the market rose, investors slowly got back into some of those sectors.

That trend, which has been a headwind for fundamental investors, appears to be reversing this year.

So far this year, as the market declines we're seeing more of an unwinding of these sector positions rather than a piling back into these positions. This suggests a change in market psychology. And it's something that we're watching closely as we manage our positions across sectors.

In response to rules-based strategies driving sector concentration, we've focused on not taking too much risk and building convexity into our portfolio—which typically entails buying options in an attempt to protect against the downside while maintaining the ability to participate in the upside.

Most of that convexity is coming from sector positions on the market side of our portfolio, such as long options on European small caps. We also have some currency option positions, particularly in Asian currencies.

We continue to look for opportunities to step into markets and currencies where we see fundamental value reasserting itself and step against some of these rules-based strategies.

After all, our team's active, dynamic approach focuses on riding the tides (long-term fundamental value), navigating the waves (medium-term macro risks), and ignoring the ripples (short-term news)—not blindly swimming upstream with the market.

Brian Singer, CFA, partner, is a portfolio manager on and head of William Blair's Dynamic Allocation Strategies team.