Weather the Storm: How to Prepare for the POST COVID Era
The shock of COVID-19 has sent rippling effects all across the world. While health and safety remain the number one priority as we race for a cure for the virus, financial well-being has become a close second. The dramatic decline in global asset prices, coupled with a record rise of 6.6mm+ unemployment claims, have put significant financial strain on families all around the world. There will be a period of rebuilding, but in the aftermath investment opportunities will emerge.
The past decade has brought an unprecedented rise to passive management as investors have flocked to the ETF and mutual fund market. According to Morningstar, over the last decade the 20 funds with the largest net inflows gathered around $1 trillion in assets and boast a combined $3.4 trillion in AUM. As reported by Bloomberg, active management has faced other headwinds such as fee competition, rising costs, and asset growth which have created never-before-seen pressure on the active asset managers.
As interest rates have remained low, investors have been unable to get an adequate return in the bond market, sparking a rush to equities. This has left investors inadequately diversified and subject to outside losses during an equity market collapse like we have witnessed. The lack of ownership of fixed income for some investors has also been painful. Interest rates have declined precipitously resulting in a boon for fixed income portfolios. As of March 30th, the U.S. 10 yr Treasury Bill is yielding 0.73%, falling from ~1.9% at the start of the year. Due to the inverse relationship between bond prices and yields, an allocation to bonds would have boded well for investor portfolios.
The rise of passive management has not been favorable to the hedge fund industry. The combination of high fees and mediocre performance across the industry has resulted in outflows, funneling even more money into long-only passive products. This strategy works well during a bull market as investors were not rewarded for diversification. The “hedge” in hedge fund is there for a reason. There are many investment strategies in the hedge fund world, but typically all provide a specific risk profile against sharp movements in the markets.
For example, a market neutral strategy has just as many longs as it does shorts. The portfolio manager is a pure stock picker, while taking no broad market risk. A simple illustration would be buying stock in Coca Cola and shorting an equal amount of Pepsi stock. The manager is betting that Coca Cola will outperform Pepsi regardless of which way the overall market moves. In this example during a market sell off, the manager would lose money on the long in Coca Cola but make it back up on the short position in Pepsi. The spread between the two price movements is what would impact the portfolios performance. Hedge funds on average have performed notably better than the S&P 500 YTD. As of March 27, the HFRX Equity Hedge Index was -13.55%, while the S&P 500 Index was -21.3%. The events of March 2020 should be a reminder to investors on the importance of diversification and that there is a place for active management in a modern portfolio.
A new asset class emerged since the last time we experienced a recession in 2008. Cryptocurrencies and digital assets have the potential to provide another avenue of diversification as well as play a key role in the build out of a more robust and inclusive financial services infrastructure. The explosion of COVID-19 across the world has once again demonstrated the fragility as “social distancing” is now a part of everyone’s vocabulary, business continuity will be a major theme of the next decade. This should come at no surprise as the stock price of Zoom Video Communications has risen over 100% in the past month. Blockchain, the underlying technology of cryptocurrencies such as Bitcoin and Ethereum, has the potential to be the building block of new companies to emerge to tackle this newly realized problem. Blockchain excels in situations that require decentralization. The technology is able to globally connect everyone with no central point control, making it much more immune to a global pandemic than our current centralized financial system.
Although COVID-19 has been a tragedy for the world, we believe many financial lessons can be learned. The market over the past decade has lulled investors to sleep and we have forgotten core principles such as diversification, managing risk, and having a cash reserve. We hope that investors take these events seriously and incorporate these re-found principles as they plan for the future.
We will get through these challenging times together and come out on the other end stronger. Stay safe everyone!
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