Investing in volatile times

Investing in volatile times    

July 2010

When stock markets are volatile, what should unit trust investors do? Should they take on more risks and ride on the economic and market recovery? This article examines the issues that investors should look out for.

At the peak of the financial crisis in 2008, the FBM KLCI fell from an all-time high of 1,516 points in January 2008 to about 800 points in October 2008. With the index having rebounded to current levels of 1,361 points as at end July 2010, an investor would have made a handsome return of almost 70% if he had invested when the market was at its lowest point.





However, it is impossible to predict the bottom of the crash and therefore timing the market is virtually impossible for normal investors. With no crystal ball in hand, the ringgit-cost averaging method could provide retail investors with reasonable returns as markets recovered. This is provided that investors have a long-term perspective and are patient enough to ride through the market’s ups and downs.

Ringgit-cost averaging strategy is designed to reduce volatility by investing fixed dollar amounts at regular intervals, regardless of the market’s direction. Thus, as prices of securities rise, fewer units are bought, and as prices fall, more units are bought.

Depending on the risk profile and objectives of their funds, professional fund managers may capitalise on market volatility by bargain-hunting oversold stocks and divesting stocks that have become overvalued. By doing so, they seek to take advantage of mispricing of assets during volatile times. Given the sophistication of these investment strategies, unit trust investors should focus on a regular investment plan and let the fund managers deal with the volatility of markets.

How should unit trust investors respond to volatility?

Past performance of unit trust funds should be evaluated based on returns and volatility. Investors should try to assess whether a funds’ volatility is caused by market conditions which affect the performance of similar funds across the board or whether it is caused by the fund managers’ investment decisions to take on more risks.

It is quite clear that the primary reason for equity funds to be volatile in recent years is due to market volatility in various financial assets. As mentioned earlier, global stock markets sustained heavy losses as the US subprime crisis spread across the world in 2008, causing global financial institutions to write off US$1.7 trillion in debts. Subsequently, equities have rebounded in 2009 following signs of a recovery in economic activities in response to the fiscal and monetary stimulus measures undertaken by governments and central banks around the world.

The commodity bubble also burst in mid-2008, led by escalating crude oil prices which hit a high of US$147 per barrel in July 2008 before plunging to US$33 per barrel in December 2008. Volatility was also seen in the foreign exchange market as the financial meltdown forced U.S. investors to withdraw offshore funds to be repatriated back home, causing the US$ to strengthen in 2008. Subsequently with the recovery in equity markets, the US$ weakened in 2009 as investors were willing to take on more risks.

With volatility still in the current market, how can investors plan their investments before putting money into unit trusts?

Volatility is often viewed as negative as it is associated with risk and uncertainty. However, with a disciplined and consistent approach, investors can position themselves to achieve potential long-term returns from the market. In general, investors seeking above-average returns should be prepared to accept higher risks in their investments.

Before investing into a unit trust, investors should evaluate whether a fund’s volatility suits his or her risk appetite. They can start by reading the fund's prospectus and annual report, and compare its year-to-year performance figures. The figures can tell investors whether the fund earned most of its returns within a short period or whether its returns were achieved on a more consistent basis over time.

For example, over ten years, two funds may have gained 12% per year on average, but they may have taken drastically different routes to get there. One might have had a few years of spectacular performance and a few years of low or negative returns, while the performance of the other may have been much steadier from year to year.

Fund volatility factor

To assist investors in their fund selection, the Federation of Investment Managers Malaysia (FIMM), formerly known as the Federation of Malaysian Unit Trust Managers (FMUTM), introduced the fund volatility factor and fund volatility classification for funds with three years track record, which is assigned by Lipper.

While historical performance may not predict future returns, it can tell you how volatile a fund has been and reflect a fund manager’s track record. In using the fund volatility factor, unit trust investors should keep in mind to compare the volatility of funds against their annualised returns. In addition, they should evaluate the returns and volatility of funds within the same peer fund category and not across different categories of funds.

Apart from the fund managers’ investing style, the volatility of unit trusts differs depending on the assets that the funds are invested in. Commodities and equities are seen as more volatile compared to bonds and fixed deposits.

For equities, industry and sector factors can cause increased market volatility. For example, in the plantation sector, a major weather storm in an important plantation area can cause prices of crude palm oil to jump up. As a result, the price of palm oil-related stocks will rise accordingly.  This increased volatility affects overall markets as well as individual stocks.

There are unit trusts that invest in specific countries or regions such as China, Australia, Vietnam, and the emerging markets such as BRIC (Brazil, Russia, India and China). These funds are prone to country risks such as political risk and financial events in the country. Investors have to be aware of the volatility of foreign stocks and bonds. Regional and country-specific economic factors, such as tax and interest rate policies, also contribute to the directional change of the market and thus volatility.

Investors of a commodity fund would normally look at demand and supply conditions to access the outlook for the commodity market. In 2008, the rally in commodity prices was partly due to growing demand from energy-hungry China and other emerging countries. However, a sharp increase in speculative demand among hedge funds for selected commodities helped to drive up these commodity prices to record levels that were out of line with their fundamentals.

Following the financial crisis, hedge funds were scrutinised for their role in the speculation. Meanwhile, global demand of commodities is expected to increase in line with the economic recovery but there is no guarantee that the hedge funds will not return and create speculative demand.

In response to the financial crisis, central banks around the world have slashed interest rates to record lows to spur economic growth. However, selected regional central banks had started raising interest rates in the first half of 2010 to curb potential inflation as economic conditions improve.

In conclusion, unit trust investors can apply the ringgit-cost averaging method in a volatile market environment. This strategy would effectively reduce volatility risks as it does not time the market. Ringgit-cost averaging is most suitable for long-term investors as it requires investors to stay invested regardless of the market’s direction. For investors with higher risk appetite, they would need to understand specific factors that affect volatility in different asset classes and geographical areas and select their funds accordingly.


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