Why volatile assets are not always a bad thing – and how you can access it?

With the whizz bang of fireworks night just gone, we thought now would be a good time to look at volatile assets and why they are not necessarily a bad thing for long-term investors.

Any investment will go up and down over time – if you’re ever shown a chart with performance going from bottom left corner to top right in a perfectly straight line, that’s usually a red flag. Much like fireworks, the ups and downs, or volatility, of investments can be intimidating to some people.

Assets that move up and down more vigorously than others can put off some investors, while creating a buying opportunity for braver souls (resembling the adventurous nature of Guy Fawkes, but hopefully with a happier ending).

Surviving small-caps

As Cormac Weldon, manager of Artemis US Smaller Companies, says, “volatile stocks tend to be cheaper than their counterparts because a lot of investors don’t like the rollercoaster ride they can bring”.

At a stock level what drives volatility are things such as balance sheet indebtedness and volatility of earnings, including whether it is a cyclical business and prone to large swings in earnings.

But often you get interesting risk imbalances when markets are volatile, says Cormac: “Suddenly, the downside risk becomes largely priced in by a gloomy market and the upside potential is widely ignored. This is where volatility can open buying opportunities.”

Small cap funds, like Artemis US Smaller Companies, can be particular beneficiaries of volatility. Cormac explains: “In times like now volatility can grow and that can affect small-cap markets more than large-cap because when people take risk off the table they often start with their smaller companies holdings.

“That may sound worrying for investors, but it actually increases the opportunities for an alert active investor who is doing their research well.”

Emerging market funds are a regularly in the most volatile charts. But the team behind FSSA’s Greater China Growth and All China funds, uses volatility to rebalance their portfolios.

“Market volatility is an opportunity to take profits on portfolio gainers, while adding to portfolio losers. Tougher trading conditions typically favour stronger companies – they may even gain market share and emerge in a stronger position than before,” they say.

Ignoring the noise and focusing on fundamentals

Earlier this year, Baillie Gifford Japanese Income Growth lead portfolio manager Matthew Brett reflected on “steering through rough seas” at the Japan Private Investor Forum*.

Compared to short term choppy waters the far more dangerous rocks and icebergs, he suggested, were irreversible behavioural shifts that can destroy the case for some stocks forever. The goal of the Japan team, he said, is to “unpick the differences between a temporary setback versus situations where we have to acknowledge that real change has happened”.

Brett highlights how the market had undervalued companies whose setbacks he believed to be merely temporary. For example, gaming giant Nintendo, where shares took a nosedive following the unpopularity of its Wii U console in 2012, triggered by competition from games on mobile phones.

Shares duly recovered, partly thanks to the popularity of its Switch handheld platform launched five years afterwards. “People were looking at the wrong things when they were looking at the consoles,” he explained.

“They were looking at the current manifestation of Nintendo’s intellectual property, rather than taking a proper long-term view, which is that Nintendo isn’t actually about those consoles – it’s about the characters, the software, the brands. That’s what made that setback temporary, rather than a permanent change, and allowed growth to return.”

Megatrends may face bumps in the road

Biotech is another sector not for the faint hearted. The S&P 500 Index is up over 9% year-to -date, largely fuelled by artificial intelligence-driven tech stocks rally, while the Nasdaq Biotechnology index is down close to 11%**.

Linden Thomson, who manages the AXA Framlington Biotech fund, notes that this year, the sector "has faced some specific challenges". These challenges are beyond the control of companies and has contributed to increased volatility.

This includes the US Food & Drug Administration delaying approvals to drugs “widely expected to be greenlighted on time”, and the Federal Trade Commission closely scrutinising some of the larger announced M&A deals.

However, the fund continues to outperform over the mid and longer-term versus the index. “Our investment philosophy focuses on quality stocks across all market caps which are led by management teams with proven track records firmly staying intact despite these challenges,” she adds.

Likewise, outside the biggest names, the technology sector has shown some underperformance over the autumn. Jeremy Gleeson, manager of the AXA Framlington Global Technology fund, says the sector is being hit by the risk-off environment, which “has again picked up steam resulting in a broad sell-off into the end of the [third] quarter”.

The thing about volatility, however, is there has to be some ups with the downs. When there isn't, the right response could be to dump the stock.

For example, Gleeson sold his position in social media manager Sprout Social in September. “The company is attempting to sell its software solutions to larger businesses, however, its exposure to smaller companies is creating a headwind to growth,” he said.

He also sold his position in Silicon Labs, a provider of semiconductors that enable connectivity for the Internet of Things. “Its consumer-focused business has been weaker and now its industrial-centric business is also suffering from a tougher economy,” he said.

Finally another volatile asset class to look at is precious metals, specifically gold and silver. Ned Naylor-Leyland, Jupiter’s Gold & Silver fund manager says: “the smaller a mining company is, the greater the volatility, as these companies are less liquid, and performance is driven by exploration news flow, successful or otherwise, as well as by gold and silver spot price movements”.

Yet Naylor-Leyland has notable winners within that part of the portfolio, including De Grey Mining.

“De Grey started off as a small investment in a small and volatile explorer but now it is a large company with a large development project courted by all the world’s major gold producers,

“The key again is sizing, “we started small, and the volatility wore off as it grew and became more obvious to the wider market,” he adds.

So there you have it – smaller, emerging companies, and riskier assets, can lead to more ups and downs, but can also mean an uncorrelated asset that provides significant diversification.

Remember this fireworks season, volatility doesn’t necessarily mean risk, and, done right, can often mean opportunity.

*Source: Baillie Gifford, February 2023
**Source: FE Analytics, total returns in sterling, 30 Dec 2022 to 1 Nov 2023

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. The views expressed are those of the author and fund managers and do not constitute financial advice.

Published on 07/11/2023