Strengthen asset allocation defenses against COVID-19


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By Sharat Kotikalpudi and Mark Gleason

The rise of the omicron variant of the coronavirus has implications not only for broader asset class allocations, but also for macro exposures within asset classes. We believe that a modest cap on exposure to certain COVID-19 sensitive assets can improve risk management.

It has been quite a challenge for investors to manage portfolio risk in the pandemic era. The sudden twists in the public health trajectory of COVID-19 have had far-reaching effects on the global economy, the outlook for individual asset classes, industries and companies, and portfolios.

The omicron variant is the latest disruptor, following on from the original coronavirus outbreak and the delta variant – each outbreak bringing uncertainty and significant short-term downside risks. One approach to dealing with these risks is to increase or decrease exposures to risky assets.

However, it is quite a crude tool, as asset classes are not monolithic. The impact of the pandemic varies widely across equities, fixed income, commodities and currencies, and sensitivities run in both directions: certain market segments benefit when outbreaks impose mobility restrictions, while others suffer.

This performance differential can be seen in US stock markets by comparing a basket of “stay-in” stocks and a basket of “out” stocks.

Home stocks, which have benefited from the COVID-19 outbreaks, include issuers such as home entertainment companies and remote work facilitators. Outbound issuers, which have held up well in the upturn in activity, include resorts and airlines. A combined long position in home stocks and a short position in exit (display) stocks rallied during both the initial outbreak, which began in February 2020, and the delta variant outbreak, which made surfaced for the first time in August 2021.

The COVID-19 divide in stock performance

Indexed return of long “stay at home” and short “exit” baskets of stocks: January 2020 = 1.00

Indexed performance of an equity strategy designed to weather COVID-19 outbreaks

Past performance does not guarantee future results. Data through January 10, 2022. The “Stay at Home” basket is represented by the Goldman Sachs US Stay at Home basket of US-listed stocks that could benefit as consumers spend more time and money at home. The stocks are equally weighted with an average daily value cap of 3% on $100 million. The “Go Out” Basket is represented by the US Global Health Risk Basket, which consists of US-listed stocks primarily in the leisure travel sectors (including airlines, hotels, gaming, cruise lines, theme parks, restaurants and shopping malls). ) likely to be impacted by the perceived threat of a global health problem. The basket is optimized for liquidity and borrowing, with no name above 1.5 times an equally weighted construction.

Source: Goldman Sachs and AllianceBernstein

Identification of assets sensitive to COVID-19 in the macro-landscape

There has been plenty of analysis focused on the winners and losers of COVID-19 among individual issuers, but we have seen little coverage of macro-asset sensitivities, such as stock and bond indices. of state, currencies and commodities, to world markets. pandemic risk.

By evaluating the performance patterns of different segments of the equity, fixed income, commodity and currency markets, we believe it is possible to isolate assets with more directional sensitivity – both positive and negative – to outbreaks of COVID-19. Oil and oil-sensitive assets, for example, struggled as lower demand for oil undermined prices. The lack of agricultural workers, on the other hand, has pushed up the prices of these products, which has benefited agricultural products. Safe-haven currencies, such as the US dollar, rallied as investors fled riskier assets.

Some assets behaved in a way that defied a clear label. The British pound, for example, lost ground during the initial wave related to COVID-19, but rose slightly during the delta variant outbreak. Other influences also played a role. Hong Kong’s stock market was also affected by heightened tensions with China during the same period, which made it harder to discern the influence of the pandemic alone.

A large basket of around 40 asset segments, with long positions in the winners of the COVID-19 epidemics and short positions in the losers of the COVID-19 (Display), clearly benefits from the initial epidemic of the beginning of 2020 and the mid-2021 delta variant epidemic. It also increases to a lesser extent during the outbreak of the omicron variant, so far more transmissible but generally less disruptive.

Assessment of the macro impact of COVID-19

Indexed returns of the COVID-19 asset basket: January 2020 = 1.00

Indexed performance of a basket of macro-assets designed to deal with the outbreaks of COVID-19

Past performance does not guarantee future results. Data through December 2, 2021. The COVID-19 Macro Basket is constructed from long positions in COVID-19 winners and short positions in COVID-19 losers, as identified by directional screening, at within stocks, bonds, commodities and currencies. Baskets of individual asset classes are calibrated to achieve an annualized volatility of 10% and then aggregated to form the overall return of the basket.


Capping of portfolio moderate risk exposures

Informed by this basket, investors can cushion portfolios against tail risks related to the COVID-19 outbreak in a more targeted way than a general change in risk. The key mechanism is to impose limits on allocations to COVID-19 sensitive assets. Limits would be unidirectional – aimed at capping exposures in the direction that would amplify portfolio risk.

Take the example of industrial transmitters. These businesses have typically suffered during COVID-19 outbreaks when economic activity globally slows. It therefore makes sense to limit the portfolio’s ability to overweight exposure to industrials, which could increase risk. The Swiss franc, on the other hand, rallied during the two previous outbreaks of COVID-19. To moderate the risk, it makes sense to cap the portfolio’s ability to underweight the Swiss franc.

These allocation limits should be relatively modest, in addition to other portfolio risk control measures. They are also not free, so they are not intended to be permanent installations. The next natural question is: in a pandemic that has been anything but predictable, how would an investor know when – and how – to remove those safety barriers?

When is protection against coronavirus variants no longer necessary?

Given the unpredictable public health trajectory of COVID-19, the best approach seems to be to adjust these asset limits in stages – and based on a broad dashboard of indicators. These signals include public health developments, market-based signals, and fundamental judgment.

On the public health front, trends in virus cases, hospitalizations, critical patients and other pandemic effects would be part of the mix. From a market perspective, the amount of COVID-19 risk embedded in assets should be considered, so the performance of different COVID-19 baskets should be closely monitored. And as stated earlier, fundamental interpretation and judgment are key in interpreting signals.

Two previous outbreaks of COVID-19 — and part of a third — make up a relatively small historical sample, which is one reason the allocation limits should be modest. Assets can behave in unexpected ways and non-pandemic factors can also affect returns. However, while it may not be a perfect solution, we believe it has the potential to enhance large-scale risk change during outbreaks – whether related to omicron or the next variant .

The opinions expressed herein do not constitute research, investment advice or trading recommendations and do not necessarily represent the views of all of AB’s portfolio management teams and are subject to revision over time.

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Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.


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