While the recent bout of volatility in markets has prompted some panic among traders, long-term investors may be able to benefit from short-term dips, according to SYZ Asset Management’s Mike Clements.
The FE Alpha Manager said that the recent spate of volatility in markets had “punctured a period of unprecedented market calm”.
As the below chart shows, volatility represented by the VIX – a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices – trended lower last year.
Performance of VIX during 2017
Source: FE Analytics
Clements – who manages the five FE Crown-rated Oyster Continental European Selection fund – said this low volatility last year had helped create a challenging hunting ground for stock-picking contrarians.
The manager said: “While this momentum-driven market offered opportunity to harvest profit, there was little in the way of alpha-generating ideas. Now the market axis is beginning to shift.”
He added that the more volatile markets seen since the start of the year can provided investors with a good opportunity for longer-term gains.
He explained: “Violent markets enable stock pickers to uncover value when the tide of sentiment draws out.
“The early dislocation in 2018 could be an early portent of a turbulent year ahead – and a sign the market may ripen for price discovery.
“For true contrarian investors, fraught markets should be welcome as they provide the conditions to extract alpha and deliver enhanced long-term returns.”
He added: “While one swallow does not make a summer, a sustained return to volatility in 2018 looks increasingly likely.
“The question is: how can investors profit from the approaching storm?”
More recently, Clements has been anticipating an uptick in volatility following after a relatively becalmed market conditions last year and has been reducing exposure to “market-level sensitive stocks” such as asset managers Schroders, Ashmore and Aberdeen over the past six to nine months.
He said: “These stocks have had a great run, but essentially, they are linked in to the overall level of the market and creeping debt.
“And as valuations and debt levels rise, we believe the investment case for these stocks diminishes.”
The FE Alpha Manager said there are some areas of financial services that can benefit from greater volatility in markets, but not all companies make good investments.
“Investment banks enjoyed a flurry of activity on the back of the ‘Trump bump’; however, these companies generally do not meet our quality criteria,” said Clements. “There are simply too many balance sheet risks, including high levels of leverage and opaque hard to value balance sheets.
“In times of stress and volatile markets, we feel these would be particularly risky investments.”
Indeed, Clements has been switching exposure from the asset managers to financial infrastructure firms instead.
“These are stock exchanges and other market participants that would benefit from a pick-up in volatility,” Clements said. “Within financials, there are a number of companies that rely on volatility to drive trading volumes, but as active investors, we use a selective lens.”
Performance of stocks YTD
Source: FE Analytics
The manager added: “Pure trading businesses like exchanges, market makers and inter-dealer brokers such as TP Icap are attractive as they combine strong returns, high levels of cash generation with exposure to volatility-driven trading activity.
“IG Group, the leading provider in spread betting and CFD [contracts for difference] products, is generally geared to volatility in the short term.
“While regulation is a key risk, IG is best positioned to adapt to the changing environment at the expense of smaller players.”
Another play on volatility by the manager is Dutch firm Flow Traders - an exchange-traded fund (ETF) market maker - with what around 20 per cent market share in Europe.
“Over the longer term, it is benefitting from the structural growth in ETFs, but, shorter term, its revenues are largely influenced by volatility,” he noted. “When this is subdued, low trading volumes and tight spreads weigh on revenues.
“However, in times of stress or market dislocation, volatility provides a kicker to its structural revenue growth.”
Clements said that while the firm’s business model delivers superior returns and cash and is well positioned for the structural growth in ETFs, “earnings are currently depressed because of the lack of volatility”.
He added: “We have capitalised on this price weakness and believe there could be significant upside if volatility returns to more normal levels.”
Financials represent an 18.1 per cent sector exposure in the portfolio, including top 10 holdings Deutsche Boerse and Dobank.
The £157.9m Oyster Continental European Selection fund targets capital growth by investing in a concentrated portfolio of European equities without reference to a specific style.
“There is a strong quality mantra underpinning the strategy but pleasingly this is coupled with a strong focus on buying these companies cheaply,” noted analysts at Square Mile Research.
“Clements could be viewed as an opportunistic investor as he believes valuation is important when buying quality companies, so he is typically purchasing stocks when they are out of favour with other investors.”
Year-to-date, the fund has risen by 0.95 per cent compared with a 1 per cent loss for the average IA Europe excluding UK fund and 1.41 per cent loss for the MSCI Europe ex UK index.
Performance of fund vs sector & benchmark under manager
Source: FE Analytics
Since Clements took over the fund in October 2014, it has delivered a total return of 69.66 per cent compared with a gain of 49.25 per cent for its average peer and a 43.10 per cent return for the index, as the above chart shows.
Oyster Continental European Selection has ongoing charges of 1.12 per cent.