By Craig Stapleton
Chief Investment Officer and Portfolio Manager, Securian Asset Management, Inc.
SECURIAN AM BALANCED STABILIZATION FUND
SECURIAN AM EQUITY STABILIZATION FUND

EXECUTIVE SUMMARY

  • Investors face a balancing act between two equally important needs: achieving competitive long-term returns while avoiding the painful consequences of near-term drawdowns.
  • Traditional asset allocation, risk parity and other strategies failed to perform as expected during recent downturns. Fixed income assets have moved closely in line with equities in times of crisis.
  • Equity volatility levels exhibit a persistent and reliable relationship with equity returns over time and through market cycles, including the latest market crisis, as illustrated for large cap U.S. equities in Chart 1.
  • A permanent strategic allocation to an equity stabilization strategy that utilizes the persistent volatility/return relationship can improve investors’ long-term risk/return ratios – even if implemented right after a market selloff. A rules-based approach, using the reliable indicator of recent volatility, can be successfully applied at any time via a spectrum of implementations against single or multiple risk asset class portfolios.

 

A Clear Relationship Between Monthly Equity Returns and Recent Volatility

Equity volatility levels have exhibited a persistent and reliable relationship with equity returns over time and through market cycles, including the latest market crisis. This phenomenon is illustrated for large cap U.S. equities in Chart 1.

Many investors face the pernicious dilemma—a double-edged sword—of having mutually conflicting needs. When building a portfolio, investors start with the understanding that, over the long term, expected return and volatility are strongly positively correlated. Unfortunately, most investors need both significant levels of return to meet their long-term goals and a stable stream of returns to ensure financial viability.

For investors seeking stability, the same risk assets that provide essential upside potential also represent significant exposure to downside risk and unstable results.

Although investors’ need for risk mitigation is high, most investors have not implemented such strategies to date, for reasons we discuss below.

Source: Bloomberg. Data as of April 1, 2020. The data spans from January 1, 1928, to March 31, 2020, and the table displays the average monthly returns for the S&P 500® for the time periods shown where the average monthly volatility was in the different volatility categories shown. Volatility is measured as the annualized standard deviation of daily returns of the index. Past performance does not guarantee future results.

The Risks of Managing Risk: Fixed Income is Not a Reliable Equity Hedge

For a risk mitigation strategy to be reliable, it must be built on a market relationship that is persistent over time. Unfortunately, most risk mitigation strategies to-date have been based on historic correlations that have broken down during strong bear markets, when they are most needed.

A common approach to mitigating equity volatility risk is the classic asset allocation strategy combining equity and fixed income assets, for example in the traditional 60/40 portfolio. The logic is that the two asset classes are negatively correlated most of the time, so fixed income serves as a portfolio’s ‘anchor to windward’ when volatile equities experience periodic selloffs.

Unfortunately, the correlation between fixed income and equity investments is not stable through time. As Chart 2 illustrates, there have been long periods where equities and bonds were positively correlated, and thus traditional portfolio diversification did not reduce portfolio risk.

In crises — when an offset to downside equity risk is most needed — equities and fixed income often sell off at the same time. During the COVID-19 crisis, the correlation between fixed income assets and equities quickly became much less negative, diluting fixed income’s portfolio diversification benefit. Further, there have been extended periods of time where fixed income was positively correlated with equity. Both are highlighted in the circles in Chart 2.


Source: Bloomberg Barclays US Aggregate Bond Index and Securian Asset Management, Inc. Data as of April 1, 2020. The data spans from January 1, 1989, to March 31, 2020, and displays analysis of two indices, the 3-month rolling correlation of the S&P 500 vs. the Bloomberg Barclays U.S. Aggregate Bond Index. The blue circles highlight the specific periods of time. Past performance does not guarantee future results.

Volatility is a Reliable Indicator of Equity Performance

A persistent and reliable relationship exists between 1-month volatility and 1-month equity returns, both positive and negative. Volatility episodes tend to demonstrate persistence. As Chart 3 below clearly shows, since 1928, for the S&P 500, high 1-month volatility tends to be associated with poor 1-month returns; and vice versa.

While we use the S&P 500 for the illustration above, our research shows the same relationship between volatility and returns across other equity markets.

A strategy based on the reliably strong relationship between equity volatility and returns is well-suited to deliver portfolio risk mitigation in a more consistent manner than traditional asset allocation. An equity stabilization strategy systematically adjusts equity exposures based on the volatility/return relationship.

This approach holds greater equity market exposure during lower volatility periods, which tends to lead to better performance, as illustrated in Chart 3. Conversely, we believe this approach can quickly reduce equity market exposure during the higher volatility periods that tend to produce unfavorable performance, mitigating the drawdown of assets.

Source: Bloomberg.

The data spans from January 1, 1928, to March 31, 2020, and the table displays the relationship between equity volatility and S&P 500® returns for the time periods shown where the average monthly volatility was in the different volatility categories

shown. Y is the linear best fit to the data points (the “scatter plot” dots). Y is the average monthly return you’d expect if you used in a volatility value (“x”). R2 is a statistical benchmark that investors can use to compare a fund to a given benchmark. Past performance does not guarantee future results.

To date, many investors have implemented volatility-based stabilization strategies sporadically or not at all. We believe this reticence is due to two key investor concerns: portfolio risk hedging is complex, and a desire to avoid periodic carrying costs of hedging—particularly right after a major market selloff.

A permanent strategic allocation to a systematic volatility-based approach over a full market cycle can address both issues.

Skillful Implementation Adds Further Value to a Stabilization Strategy

A skillful stabilization strategy can benefit balanced portfolios as well. Using a volatility-based risk mitigation strategy on the equity portion of a balanced portfolio may be an effective way to adjust the equity/bond mix to changing risk environments, without the costs and timing issues of selling the underlying assets.

What’s more, when a volatility-based portfolio risk management approach is maintained throughout a full market cycle, its outperformance in down markets can offset its underperformance in up markets, rendering a market-like return over a full cycle.

Portfolio Hedging is Important after a Market Selloff

Perhaps counterintuitively, a volatility-based stabilization strategy is important after a severe market shock, such as the recent COVID-19 pandemic shock.

After an historic downturn in the markets, most portfolios are significantly underweight equities. In order to benefit fully when the markets inevitably recover – and in order to rebalance to their strategic asset mix targets – investors may need to re- risk by adding to their equity exposures.

This may be a difficult decision for many investors because the market bottom is only known to have occurred well after the fact. A reliable risk management strategy, such as the kind of volatility-based approach described in this paper, may enable investors to re-risk without needing to have certainty about the market bottom, as it may entail significant protection against further drawdowns and yet can participate when the market recovers.

Summary: A Permanent Allocation to Volatility-Based Risk Mitigation May be a Solution for Investors

An airbag must be permanently installed in a car for it to deploy when it is needed – during the moment of impact, the timing of which cannot be predicted. Similarly, we believe investors obtain the best results from a stabilization approach based on volatility when they make it a full-time strategic allocation in their portfolios.

With a permanent strategic allocation to volatility-based stabilization, investors can benefit from the consistent and sustained mitigation of volatility shocks on an ongoing basis.

In summary, a strategic use of a volatility-based equity stabilization strategy to mitigate portfolio risk can help facilitate:

  • Greater equity market exposure in lower volatility periods that may lead to better performance
  • Reduced equity market exposure in higher volatility periods that may lead to unfavorable performance
  • Reduced impact of drawdowns

About Craig Stapleton

As CIO of Securian Asset Management, Inc. Craig Stapleton is responsible for investment policy for public securities and risk. Craig has been active in the investment industry since 2002. Craig is one of the co-portfolio managers of the Securian AM Balanced Stabilization Fund and Securian AM Equity Stabilization Fund. He is also involved in the quantitative analytics and risk management of the Securian AM Real Asset Income Fund. Craig is a member of Securian Financial Group’s Risk Council. Craig is a CFA Charterholder, and a member of the CFA Institute and CFA Society of Minnesota. He holds the Financial Risk Manager designation from the Global Association of Risk Professionals. Craig has an MBA in Finance and Bachelor of Science in Computer Engineering, both from the University of Illinois.

About Securian Asset Management, Inc.

Securian Asset Management, Inc. is the sub-advisor to the Securian AM Balanced Stabilization Fund and the Securian AM Equity Stabilization Fund.  As a financially stable non-public company, Securian Asset Management focuses on the long-term and execute consistently for is clients. Its asset management business has been built with a risk and liability management focus, coming from its long, successful history investing for its parent company’s general account. Securian Asset Management stays true to its purpose, its values and its St. Paul, MN roots, while being innovative and nimble to help prepare its clients to meet their investment objectives from a position of strength.

About Liberty Street

The Liberty Street Funds offer investors and financial advisors mutual funds sub-advised by independent boutique managers who possess expertise in their asset class. Because Liberty Street Advisors, Inc. (“Liberty Street”), the advisor to the Liberty Street Funds, focuses on boutique managers, financial advisors can provide value-added strategies in actively managed and less-correlated portfolios to their clients. Through its selective multi-manager family of funds, Liberty Street provides access to timely investment strategies.

For more information, financial professionals should contact their wholesaler by calling HRC Fund Associates, LLC at libertystreet@hrcfinancialgroup.com or 212-240-9726. HRC Fund Associates, LLC, Member FINRA/SIPC, is an affiliate of Liberty Street and serves as wholesaler for the Liberty Street Funds. Individual investors and shareholders should contact their financial advisor, or the Funds at 800-207-7108.

Risk and Other Disclosures

Investors should consider the investment objectives, risks, charges and expenses carefully before investing. For a prospectus with this and other information about The Securian AM Balanced Stabilization and Securian AM Equity Stabilization Fund (the “Funds”), please visit the Funds’ website at LibertyStreetFunds.com or call 1-800-207-7108. Read the prospectus carefully before investing.

An investment in the Securian AM Equity Stabilization Fund is subject to risk, including the possible loss of principal amount invested and including, but not limited to, the following risks: Market Turbulence Resulting from COVID-19: The outbreak of COVID-19 has negatively affected the worldwide economy, individual countries, individual companies and the market in general. The future impact of COVID-19 is currently unknown, and it may exacerbate other risks that apply to the Fund. Managed Volatility Strategy Risk: The securities used in the strategy are subject to price volatility, and the strategy may not result in less volatile returns for the Fund relative to the market as a whole, and they could be more volatile. Derivatives Risk: Derivatives involve special risks including leverage, correlation, counterparty, liquidity, operational, accounting and tax risks. These risks, in certain cases, may be greater than the risks presented to more traditional investments. Liquidity Risk: The Fund may invest in illiquid securities which involve the risk that the securities will not be able to be sold at the time or prices desired by the Fund, particularly during times of market turmoil. Short Sales Risk: In connection with establishing a short position in an instrument, the Fund are subject to the risk that they may not always be able to borrow the instrument, or to close out a short position at a particular time or at an acceptable price. ETF Risk: The market price of an ETF fluctuates based on changes in the ETF’s net asset value as well as changes in the supply and demand of its shares in the secondary market. It is also possible that an active secondary market of an ETF’s shares may not develop and market trading in the shares of the ETF may be halted under certain circumstances. The Fund may not be suitable for all investors. ETN Risk: ETNs are unsecured debt obligations and are subject to the credit risk of their issuers and will lose value if the issuer goes bankrupt. ETN returns are linked to the performance of designated indices which fluctuate due to market changes as well as economic, legal, political, and geographic events. The market price of ETNs fluctuates as their returns fluctuate and as the level of supply and demand for the ETNs change.

An investment in the Securian AM Balanced Stabilization Fund is subject to risk, including the possible loss of principal amount invested and including, but not limited to, the following risks: Market Turbulence Resulting from COVID-19: The outbreak of COVID-19 has negatively affected the worldwide economy, individual countries, individual companies and the market in general. The future impact of COVID-19 is currently unknown, and it may exacerbate other risks that apply to the Fund. Managed Volatility Strategy Risk: The securities used in the strategy are subject to price volatility, and the strategy may not result in less volatile returns for the Fund relative to the market as a whole, and they could be more volatile. Fixed Income Securities Risks: Investments in debt securities typically decrease in value when interest rates rise. The risk is usually greater for longer-term debt securities. Derivatives Risk: Derivatives involve special risks including leverage, correlation, counterparty, liquidity, operational, accounting and tax risks. These risks, in certain cases, may be greater than the risks presented to more traditional investments. Rule 144A Securities Risk: The Fund may invest in illiquid securities which involve the risk that the securities will not be able to be sold at the time or prices desired by the Fund, particularly during times of market turmoil. Short Sales Risk: In connection with establishing a short position in an instrument, the Fund is subject to the risk that they may not always be able to borrow the instrument, or to close out a short position at a particular time or at an acceptable price. ETF Risk: The market price of an ETF fluctuates based on changes in the ETF’s net asset value as well as changes in the supply and demand of its shares in the secondary market. It is also possible that an active secondary market of an ETF’s shares may not develop and market trading in the shares of the ETF may be halted under certain circumstances. ETN Risk: ETNs are unsecured debt obligations and are subject to the credit risk of their issuers, and will lose value if the issuer goes bankrupt. ETN returns are linked to the performance of designated indices which fluctuate due to market changes as well as economic, legal, political and geographic events. The market price of ETNs fluctuates as their returns fluctuate and as the level of supply and demand for the ETNs change.

The Funds may not be suitable for all investors. We encourage you to consult with appropriate tax and financial professionals before considering an investment in the Funds.

The S&P 500 Index consists of 500 large cap common stocks which together represent approximately 80% of the total U.S. stock market. It is a float-adjusted market-weighted index (stock price times float-adjusted shares outstanding), with each stock affecting the index in proportion to its market value. Bloomberg Barclays US Aggregate Bond Index: measures the investment grade, US dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, mortgage-backed securities, asset-backed securities and commercial mortgage-backed securities. One cannot invest in an index.

Volatility is measured as the annualized standard deviation of daily returns of the index. Standard Deviation is the statistical measure of market volatility, measuring how widely prices are dispersed from the average price. If prices trade in a narrow trading range, the standard deviation will return a low value that indicates low volatility. Correlation is a statistic that measures the degree to which two securities move in relation to each other.

The views in this material were those of the Fund’s Sub-advisor as of the date written and may not reflect its views on the date this material is first disseminated or any time thereafter. These views are intended to assist shareholders in understanding the Fund’s investment methodology and do not constitute investment advice

Liberty Street Advisors, Inc. is the Advisor to the Fund. The Fund is part of the Liberty Street family of funds within Investment Managers Series Trust.

The Fund is distributed by Foreside Fund Services, LLC.