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The Financial Crisis Is Different This Time

Written by: Kelly Ye, CFA

The root cause of 2007-2008 Global Financial Crisis was housing, with the mania for buying and selling homes transmitted to the financial system through mortgage-backed securities and other financial instruments, eventually exposing flaws in the funding mechanisms for many banks. It was, in short, primarily a credit problem.

This crisis is different, at least when it comes to the triggering event, something I discussed in my last blog post.

It’s the first time in modern memory that an economic contraction has been initiated by a pandemic. The abrupt shutting down of the global economy that has resulted is again unprecedented, a phenomenon becoming known as the Great Cessation. Economic activity declined sharply with the shelter-in-place orders, and unemployment has spiked. Restaurants, retailers, and others have closed, one hopes only temporarily, as the country deals with the impact of COVID-19.

The market response has been just as abrupt – a short, sharp drop in the value of global equities. Many parts of the bond market sold off, too, as investors became concerned about the ability of corporations, mortgage holders and other borrowers to continue to service their debt. Among many other things, dramatic developments like these provide a real-world test for investment strategies, including alternative investments and liquid alternative exchange-traded funds (ETFs).

Alternative investments derive their return from sources other than traditional market performance – such as the rise and fall of S&P 500 or the Dow Jones Industrial Index, for example. A merger-arbitrage strategy seeks to capture the deal premium between the target company stock price and offer price by the acquirer. IndexIQ-Merger Arbitrage ETF The risk involved is deal dependent and generally has a low correlation with equity market movements. A multi-strategy hedge fund takes bets on the relative value between securities or sectors or on global trends. These types of strategies tend to have very different risk-return profiles than the broader equity market. In the recent volatile period, they have experienced smaller drawdowns compared to S&P 500.

As the more recent rally has shown, markets can move sharply up as well as down – all in a very short period. We’ve seen stocks fall from all-time highs into a bear market (a loss of more than 20%) in just 15 days. Conversely, equities posted their best week in 11 years for the week ending March 27th.

This demonstrates again how hard it is to time the market; to maximize returns you have to get it right both coming and going. More recently, the market has shown more signs of stability, but a sustained rise will likely be dependent on both better news on the coronavirus front and greater clarity about just how long it will take to get large parts of the economy back up and running. Thankfully, there is some hope there, too. Wuhan in China, where the disease first surfaced, has started to reopen and in Europe, the data out of Italy has started to show some improvement.

In the meantime, a diversified portfolio that includes an allocation to liquid alternatives can help investors maintain exposure to the market. How much to invest in alternatives depends on an individual’s investment goals and target risk level, but an allocation of 10-20% should be sufficient to achieve meaningful diversification. This can be drawn from the equity side to reduce equity risk or from a fixed income portfolio to diversify away from interest rate risk.

While we may not have yet turned the corner on COVID-19, we no doubt will at some point. As Dr. Birx mentioned “There’s no magic vaccine for the virus It’s just behaviors.”1 Each one of us is responsible for the trajectory of the path forward. Similarly, there might not be a magic investment strategy that can address all your financial needs, but  your disciplined behavior will help build a resilient portfolio over the long term. So, stay strategic and stay diversified.

Related: This Crisis Is Different in Some Ways, Alike in Others

1. Dr. Deborah Birx; 3/31/20, White House briefing on the Coronavirus Pandemic.