Despite the ongoing global health crisis, broad swaths of the fixed income market—except for munis—have retreated toward median valuation levels from the last 20 years. Relative to US Treasuries, 10-year AAA muni yields remain in the most attractive historical decile, with 5- and 30-year maturities similarly situated. Although absolute municipal bond yields are thin, Treasury yields are thinner. The global earnings shock has left the US equity in the richest decile and developed equities outside the US are in the richest quartile. Only emerging-market equity segments show signs of value, with PE ratios approaching the bottom quartile. The speed and breadth of the recent recovery, aided by an ocean of fiscal and monetary stimulus, have largely erased most signs of the ongoing crisis.
For an idea of how investors are responding to recent volatility, we can look at closed-end funds (CEFs) investing in each asset class. CEFs are launched via an IPO process to invest in specific investment strategies, typically segregated by asset-class focus. Once listed, investors trade at the prevailing market prices instead of at net asset values (NAVs). Unlike open-ended mutual funds or ETFs with fair-value or NAV-based pricing mechanisms, CEF market prices generally drift away from NAVs, offering either a discount or premium as market prices drift below or above NAV. Institutions explain a minority of CEF ownership, causing CEF prices to more cleanly reflect retail fears and fads.
The magnitude of these pricing disparities, as measured across the capitalization-weighted Morningstar US CEF Category Average Discount Indexes, offers insights into market-clearing prices at which individual investors are willing to own different risks.
Weekly Morningstar US CEF category average discount indexes by asset class
Sources: Morningstar, Parametric, 8/31/2020. For illustrative purposes only. Not a recommendation to buy or sell any security
Based on the evolution of CEF discounts above in 2020, individual investors clearly became more risk-averse going into March and responded favorably to increasing policy intervention. However, heightened risk aversion has allowed discounts in most asset classes to remain quite elevated. Although March 18’s dislocation was intense, individual investors have yet to fully reembrace risk across major asset class categories at precrisis levels.
Even if early drawdowns have largely disappeared, volatility has become a defining feature of 2020. The rocky path of vaccine development, shifting policy, and social unrest at home and abroad each support elevated volatility ahead. Although aggregate asset-class benchmarks reflected little stress by the end of August, individual investor trading in CEFs reveals pervasive fears across risk assets.
In place of forecasting the future, investors can consider multiple approaches to benefit from volatility:
• Equity portfolios diversified across market capitalization and geography benefit from cross-sectional volatility through active loss harvesting and by attenuating extreme realizations.
• Option portfolios can extract a premium when future volatility fears exceed realized levels.
• Bond portfolios offer ballast to procyclical holdings and allow efficient cross-asset-class rebalancing.
• Nontraditional income portfolios—including access to inefficient CEF markets—provide high cash flow utility during disrupted markets.
The common thread: research-driven and systematically implemented offerings address client objectives by extracting benefits from a volatile world.
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