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The Actuary The magazine of the Institute & Faculty of Actuaries
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Market turbulence impacts on asset allocation at Iveagh Wealth Fund

Process and strategy
"Our process started to flag caution in May. We started to steadily reduce risk within the portfolio, taking profits in equities, while awaiting further confirmation on the outlook.

"Entering July, the macro models indicated that the bear case was continuing to build, with no improvement in growth indicators. Policy risks such as the Eurozone situation and US debt ceiling talks posed additional risks. Technical indicators gave us strong signals that the next move in markets would be powerful, but without clear directional guidance at that stage.

"As July progressed, the overall process signals continued to deteriorate with US growth prospects beginning to prompt particular concern. We cut risk some more, reducing equities and building a book of put options to protect against a significant fall in markets. Achieved volatility in the fund fell to around 3% (30 day, annualised).

"Markets cracked in the last two weeks of July and first week of August, with significant declines in global equities and rapidly increasing volatility. Renewed focus on Spain and Italy saw 10 Year Italian Government Bond yields close at 6.26% on 2 August, a level that raised serious concerns about the Italian government's ability to service its debt.

"Over the two week period from 22 July, S&P Index returned -14.19%, and Eurostoxx Index returned -17.52%. On 8 August, volatility as measured by VIX Index was at an historically elevated level of 48."

US debt downgrade
"On 5 August, S&P announced a downgrade in US Treasuries from AAA to AA+. The downgrade leaves US Treasuries rated below eighteen other sovereigns and in the company of Belgium with respect to credit security. S&P has also highlighted a "negative" outlook with a "one in three" chance of further rating declines in the coming months.

"To an extent this adds little to our macro outlook, simply providing more confirmation of the well discussed structural shift of savings from West to East and the concurrent erosion of confidence in the US' status as world reserve currency/banker. This phenomenon is already well exhibited through the long term trends in the gold price (up) and trade-weighted Dollar Index (down).

"The downgrade has not had a major impact on the fund. Most of the sovereign exposure is through 10 Year Australian Government Bonds whose AAA rating is not in doubt, but where the yields remain attractive. However, the fund does have approximately 5% invested in long-dated (30yr) US Treasuries. The yields at this end of the yield curve do now look attractive compared to the 10 year yield. If deflation fears really take hold, and/or the Fed intervenes in markets, this is the end of the yield curve which is likely to benefit the most."

Fund performance
"The overall fund performance during this period reflects our conservative positioning and tactical hedging. In July, the fund was flat with volatility very well contained – never more than 5% – even as equity markets around the world suffered significant declines ranging from -3% to -9%. In the momentous first week of August, when the S&P was down 7.2% and the Eurostoxx 50 down 11.1%, the fund fell 0.9%. Significant positive contributions came from positions in Australian Government bonds - one of a dwindling band of unimpeachable AAA credits - and put options which helped offset any declines on an already much reduced equity exposure. We also hedged the portfolio using volatility trackers – volatility being one of the few things guaranteed to go up when markets fall.

"As markets fell, we started to unwind downside protection, locking in profits. Cautious though we are, recent moves have been extreme, and markets started to look oversold. The valuation case for equities got stronger, especially in Europe. Meanwhile, the valuation of defensive assets - especially major market government bonds – moved radically in the other direction. On 10th August we made some moves back into risk assets, selling bonds and adding to equities. This we supplemented with call options on the market. The aim of the exercise was to make sure we had enough exposure to a rally in risk assets, without betting the farm – because, unfortunately, the medium term outlook remains cloudy."