The first quarter certainly exhibited a characteristic of capital markets that had been forgotten by many investors – volatility! While the S&P 500 produced a slight gain in the first quarter, significant volatility returned to the market as we expected – it was down almost 6% in January, followed by a recovery into March, and another sharp downturn in early April. After several years of smooth sailing on the back of Federal Reserve’s quantitative easing, the equity market has finally begun to “normalize,” forcing investors to reset their investment framework to focus on economic and earnings fundamentals.
We often hear the phrase “risk on/risk off” used in financial media and by investment professionals. The term implies that most investors tend to take risks when the markets are friendly, and shun risks when markets are volatile. We would argue that investors cannot avoid risks – even holding cash is risky on several fronts. The point is to construct a robust portfolio of varying types of risks (i.e. price risk, liquidity risk, spread risk, default risk, correlation risk, and tail risk) thoughtfully so that one does not have to be subjected to the herd mentality of risk on/risk off. We are focused on taking advantage of herd behavior by taking risks when they are priced at attractive levels.
While most asset classes seem fairly priced today, we are working diligently to anticipate risks and opportunities over the course of the next 12-18 months and retain ample liquidity reserves to buy when the herd is selling. Fundamental security selection should again be a major source of alpha, and opportunities should reside in both the long and short side of the market. In the meantime, we continue to focus on assets and strategies where risk/rewards are both definable and favorable.