Volatility: Finding True Diversifiers

Volatility: Finding True Diversifiers

Anu Rajakumar: In recent weeks, markets have been gripped by heightened volatility, reacting to the new cycle with rapid shifts and uncertainty, challenging even the most seasoned investors. As portfolios are tested by these turbulent conditions, the importance of diversification and resilience has come sharply into focus. How can investors prepare portfolios for such unpredictable environments? Do true diversifiers really exist? How can you assess their value in an asset allocation context?

My name is Anu Rajakumar, and joining me today are my dear colleagues, Robert Surgent, Senior Portfolio Manager and Head of Fundamental Tactical Asset Allocation, and Maarten Nederlof, Head of Portfolio Solutions, and also known as the portfolio doctor, to discuss how to survive and potentially even thrive amidst market volatility. Bob, Maarten, welcome back to Disruptive Forces.

Robert Surgent: Thank you very much. I can't believe I'm here with a doctor. I didn't know that. [laughter] It's great to be here anyway, thanks.

Anu Rajakumar: Now, as we all know, policy uncertainty has bled into broad market uncertainty, and in this somewhat stressful time, many investors are asking about diversifiers to their investment portfolios. Now, Maarten, as we said, we sometimes call you the portfolio doctor. We may have to check those credentials after the show, but you spend a lot of your time diagnosing our clients' portfolios. In your experience, what are investors looking for when it comes to these so-called diversifiers?

Maarten Nederlof: I find that investors are often talking about totally different things when they start talking about diversifiers. The most common definition of diversifiers are assets or strategies that behave differently from traditional stocks and bonds, especially in times of market stress or economic shifts. I've really found that there's different types. There are people that seek differentness and other people that seek compensation. For differentness, I want investments that behave differently than my main assets. If I'm looking for compensation, I want something that pays me during bad times.

If we're seeking differentness, we might, for example, rely on bonds to diversify equities or insurance-linked securities to diversify traditional capital market investments. These are different economic processes underneath those, and that's why they behave differently. If we're seeking the compensation type, we might buy insurance on our investments in the form of put options that compensate us when our primary risks decline in value.

There are other forms of diversification, for example, diversification over time. For example, private equity and public equity are not fundamentally that different, but in the inherent smoothing of private equity realized returns, those smooth returns can result in very different investment experience and sufficiently different from how public market investments behave over time and combining public and private investments can actually create a lower risk investment than either one by itself.

Then another type of strategy, which is one I think we're going to focus on today, is strategy or dynamic diversification. Compared to holding stocks, for example, a strategy that holds varying exposures over time can look quite different. Trend-following strategies and global macro strategies are good examples of this. These strategies time their exposures, and as a result, their returns can be quite different than a traditional long-only buy and hold strategy. Instead of being only long or short all the time, they enter and exit positions to capture opportunities in markets. These are strategies that often thrive in volatile times, just when buy and hold strategies simply hang on and endure the ride.

Anu Rajakumar: Great, thank you very much. That's a perfect segue to Bob. Bob, you have spent decades managing global macro strategies through a number of inflection points in history, let's say. Global macro is probably what Maarten would categorize as more of this dynamic form of diversification. Tell us first in your words, what is global macro, and why do you think it's been effective through multiple market cycles?

Robert Surgent: Sure. I'll make it very simple. Global macro is a process that tries to make money regardless of what's going on in the world. There's no benchmark. When I came into asset management, I thought benchmark was something you got in your pants when you sat on the seat of a baseball game.

[laughs]

That's because I grew up in a world where no matter what happened, the job was to make money, and that's how you're compensated. Specifically, macro is just short for macroeconomics. Macroeconomic investors attempt to benefit from monetary flows that are based on growth inflation outlooks, based on central bank and policy, maker's reactions, and then they create trends and then based on mispricings in those trends relative to the first two. You can answer that question in a much longer manner, but actually, it's just an absolute return process that invests in multiple asset classes and is very dependent upon cross-asset interaction and what that is telling you about the reflexivity of economics to asset prices.

Anu Rajakumar: Great. Thanks. Maarten, in one of your earlier responses, you mentioned that some investors seek differentness, and the example that you gave was relying on bonds to diversify equities in a portfolio. Of course, that only works when there are negative correlations between stocks and bonds. However, there's been a lot of recent talk about the increasing correlations between stocks and bonds. Talk a little bit more about what that means in a portfolio and why that might be a concern.

Maarten Nederlof: Let's talk about what we mean by correlation in the first place. Correlation is how two things move together. A high correlation means they're similar, a negative correlation means they move in opposite ways, and a low or zero correlation means they're unrelated. Some examples, private equity and credit are positively correlated with equities. They don't make great diversifiers of the type we're discussing today. Global macro and insurance-linked investments have low or zero correlations. These are the good examples of the differentness type diversifiers we mentioned earlier.

Compensation types during times of stress require negative correlation. They need to deliver when equities don't, for example. Some macro strategies tend to deliver this. There are other simpler investments that have negative correlations to equities, but those can be a drag on performance. For example, stocks and bonds are often historically negatively correlated, but there are some times, especially during recent inflation shifts, where they've become positively correlated, which is definitely not what you want in times like 2022.

Anu Rajakumar: Yes, absolutely. Just as a reminder to all of us, in case we forgot, 2022 was a really tough year for both stocks and bonds. Both were down double digits.

Anu Rajakumar: Bob, could you also touch on the importance of market structure and liquidity, especially in light of disruption in treasury markets in recent days?

Robert Surgent: Yes, that's a great question, and it's very important. It's one of the parts you asked me earlier, what's macro trading about? It's such a long answer, but you should definitely include the focus on market structure. Most recently, without going into the details, disruption in the treasury market could definitely be one of the reasons why we saw the announcement recently of a 90-day reprieve, let's put it that way, especially when the administration has stated the importance of the 10-year treasury for the US economy. In macro, you're constantly looking for these type of disruptions and moves.

Another great example we saw of it was last August. Max Yen has started to roll over, and people are like, "Why is he talking about Max Yen?" It rolled over a month before everyone got concerned that there was a recession issue in the US when US equities rolled over. I still am on record saying that wasn't a recession concern. That was a market structure concern. The buildup and assets allocated to those that were vol selling and risk premium harvesting and the epicenter of that position was Max Yen. If you're just an individual equity guy not looking at Max Yen, you would not have known that that was coming. We’ve had tons of examples like that. We know policymakers are extremely sensitive to disruptions in credit markets and in risk-free asset markets such as the Treasury.

Anu Rajakumar: Now, earlier, I think Maarten, you mentioned that there are these regime shifts which present opportunities, particularly during extreme times. Bob, can you describe a couple of examples of these for our listeners?

Robert Surgent: Sure. 2022 was one that was a rather extreme one. We've had a regime shift this year, which I think is an excellent example. If you looked at what cyclicals relative to defensives in the equity market were pricing in terms of nominal growth, it was something above 5%, and this is after quite aggressive Fed tightening that occurred in 2022 up to 2023. All you really needed was a slight reduction in the growth rate, and the market was incredibly sensitive in terms of a re-rating.

I know that people blame the tariff wars, but I am one that believes that you would have seen at least some semblance of what we saw even with just fiscal withdrawal because it was highly unusual. The setup that was highly unusual was the fact that we had credit spreads tightening, nominal GDP going up, multiples going higher at a time when the Fed was going through one of its aggressive tightening policies in history. That was the asymmetric setup that led us to where we are now.

People now can blame what's going on with the Trump administration. I'm not going to take one side. Of course, tariffs have something to do with that. People can blame what's going on with the fiscal response, but you were at such an extreme that the asymmetry was that you could get something rather nasty, which we are seeing, just from any small reduction in the fiscal outlook or the growth outlook.

Anu Rajakumar: Maybe just to follow up with that, Bob, are there opportunities that as you evaluate them, you reject because the asymmetric setup is just not asymmetric enough, or said another way the juice is just not worth the squeeze?

Robert Surgent: [chuckles] Yes. There are processes out there that act very much like insurance firms that will literally do VaR harvesting, risk premium harvesting. We stay away from that because we're very much aware we're part of a portfolio diversification process. Don't get me wrong, that doesn't mean that we won't get long equities. Yesterday morning, actually, we shorted some vol because of where puts were. It's not like we're sitting there always looking for disaster, but yes, we typically won't engage in carry strategies just because of the asymmetry.

For lack of a better term, don't get me wrong, there's definitely a place for them, but they tend to eat like a bird and then poop like an elephant. We prefer to do the opposite.

Anu Rajakumar: I've got a very weird visual in my head on that. [laughs]

Robert Surgent: Sorry about that.

Anu Rajakumar: Maybe just, again, to stay with you, Bob, just to help folks understand, putting all this together, particularly during what has been a very volatile period, would you say that you're more active during those volatile periods in terms of your trading or during calmer periods?

Robert Surgent: That's an excellent question because first, you have to define what active versus calm is. I'm very fortunate to work with a number of really good analysts, and we are incredibly active every day analyzing what's going on in the markets. What are markets mispricing? Where are the two standard deviation moves? The activity really is in spotting the imbalance that can lead to asymmetry, but that's not what we do solely. This is just a byproduct of what we're doing daily. That is why this year we were able to benefit from it.

The falsehood that I hear in the markets all the time is, "Oh, volatility is a great time for traders. Oh, I want to have this process now because--" Once the volatility hits, it's too late. It's what you did before the volatile period and being set up for the asymmetry. That's why part of a good diversifier you'll see is that the implied volatility, the P&L, goes up as the P&L does well. That's a sign of some process that's able to spot those asymmetries in the market. People may say, "Oh, you're not doing much in peacetime." That's not true at all. The results of doing well in volatile times is because of all the work you were doing in what people like to call peaceful or calmer times.

Anu Rajakumar: Excellent. Thank you very much for that. Today, we've been speaking about these diversifying strategies that are uncorrelated. I'm going to ask both of you this important question as we wrap up here. As folks are thinking about these diversifiers, what would you suggest are questions that should be asked of portfolio managers that are managing these so-called diversifying strategies to help them determine if they truly are actually diversifying to their more balanced portfolios. Bob, maybe you first.

Robert Surgent: That's a great question. That's a very simple one. Let's make this simple. First of all, what was the return of the process in '21 and '22? Not what was it versus your benchmark? Did you make money in '21?

Anu Rajakumar: That's because 2021 was a very good year for markets [crosstalk]-

Robert Surgent: Exactly. In '08, '09, I would ask the same question. Did you make money in both those years, and then right now, how did you do last year, which was a very good risk year, versus how did you do this quarter? Which was-

Anu Rajakumar: The first quarter, 2025.

Robert Surgent: Exactly. That's the first starting point. Number two, go through these processes and see what their beta is. Processes with a beta of 0.3 or a higher, which you'll find in a lot of processes that say they're diversifiers, that's not a true diversifier. You can have betas that touch 0.3, but over a long period of time, you want the beta around a zero, or I don't know, something that's much more than a 0.1 to minus 0.1. You also don't want something that's always short.

Anu Rajakumar: You say beta to global equities is what you're suggesting.

Robert Surgent: To global equities and acqui as well, because a lot of people that just lean on credit. The other one is, is it truly multi-asset class? Can you show evidence that the investor portfolio manager process, whatever it is, is profitable across all multiple asset classes, or actually, are they posing as a multi-asset class macro go-anywhere fund that literally has 70% of its P&L from equities or credit? That's the next one. Then finally, what's really important and what the essence of this type of process is, is your risk management, i.e., what is the annual return versus the drawdown?

People focus a lot on this VaR metric, which is really-- Again, I can't say strongly enough, VaR is only useful until you need it, and then it's not. What you really want to do is look at what is the return of the process relative to the drawdown. That should be at minimum one-to-one, probably more two to three to one, and that tells you if you have a true diversification product. Then the last one for the investor, once they throw out 95% of the people that say they're diversifiers that aren't, when they go through those metrics, what's unique about it, and how does it fit in, and when does it really help me out?

You don't want to a diversifier that sits there and doesn't do anything or loses money 90% of the time because that's just a put strategy. We can throw that out, but just the thought.

Anu Rajakumar: No, thank you. Now, Maarten, same question to you. Again, as the portfolio doctor diagnosing client portfolios and really assessing their exposures and understanding where they do have true diversifiers in, what would your advice be to investors who are faced with a prospective diversifying investment?

Maarten Nederlof: I don't want to torture the medical metaphor, but sometimes what the patient tells you they're doing is not necessarily what's going on, and that's where proper testing comes into account. I think for this, I'm with Bob in that in a very unconstrained investment process, like a global macro manager, the fact that they have such free reign means you really need to verify what they're telling you. That ultimately comes down to looking at past performance, as Bob suggested.

Look, I think we're supposed to say somewhere around at this point that past performance is no guarantee of future results, but it turns out in my experience, and in our role, we've looked at well over 10,000 managers in the last 10 years. Great portfolio managers are typically disciplined. They're disciplined individuals and disciplined teams. That means that you should be able to anticipate how they behave in different environments. Studying past behavior can help you figure out both during peaceful periods and during periods of imbalance, and during periods of regime shift, does the evidence in their performance back up what they say they're doing in those regimes, and how do they handle the transitions between them.

Anu Rajakumar: Absolutely. Thank you so much for sharing those thoughts. Now, I can't let you go without asking both of you a very quick bonus question.

Robert Surgent: Oh-oh.

Anu Rajakumar: [chuckles] Oh-oh, exactly. I'm fortunate to know you both well and know that you are well-traveled folks with interesting hobbies and unique life experiences. I'd love to know what are some epic things that you have checked off your lifetime bucket lists or are hoping to check off in the near future.

Robert Surgent: You want me to take that, Maarten?

Maarten Nederlof: Yes, you go ahead.

Robert Surgent: The one I've checked off was getting a job as a portfolio manager at Neuberger Berman. That was epic. The one I would like to is, because of a recent injury for two years, I haven't been able to surf with my daughters, which is something I've always done with them growing up, and I've always promised that one day we'd go surfing in the Maldives. I definitely want to check that one off one day if all goes well.

Anu Rajakumar: That sounds fabulous. Very nice. Maarten, what about you?

Maarten Nederlof: I did skydiving when my youngest son turned 18. His mother had told him, "There's no way you're skydiving while you're still a child under my care." On his 18th birthday, we went to Northern New Jersey and jumped out of a cruddy little plane. I, of course, had to go along with him. That was a pretty wonderful experience, but I probably won't do that again. Instead, just a few weeks ago, I was in New Zealand, and I jumped off of the roof of the tallest tower in the Southern Hemisphere on a zipline. That was pretty amazing, and so much so that now I want to go back and do a proper bungee jump in New Zealand. That's on my calendar for next year.

Anu Rajakumar: That's great. As a risk management professional, that's wonderful to hear, Maarten.

Maarten Nederlof: Yes, exactly. These are the people you want managing your investment.

Robert Surgent: You just lost your doctorate.

[laughter]

Anu Rajakumar: Thank you both for sharing that. Today, we navigated the complexities of resilience amidst market volatility and explored the nuances of true diversifiers. I especially appreciated, Bob, your comments about how the best preparation for navigating market volatility actually happens during calmer periods and not during the midst of that turbulence. A big thank you both to Bob and Maarten for sharing your experience with us today, and I hope to have you back on the show soon.

Robert Surgent: Thank you very much, Anu. Thanks, Maarten.

Maarten Nederlof: Thanks, Anu.

Anu Rajakumar: To our listeners, if you've enjoyed what you've heard today on Disruptive Forces, you can subscribe to the show from wherever you listen to your podcasts or you can visit our website at nb.com/disruptiveforces, where you can find previous episodes, as well as more information about our firm and offerings.