Buying on the market dip

The last three years have seen persistent volatility in equity markets worldwide. As investors try to digest and cope with the implications for their portfolios they deal with it in different ways. Some will be untroubled and seek to maintain or even add to their equity exposure on a long term buy and hold basis. At the other end of the scale many will take fright and retreat to cash or short dated bonds until they feel safe. These two reactions can be just as true for individual and institutional investors. In previous times of volatility in recent decades these strategies have met with varying results and there is clearly no single right way to manage such situations.

How do investors react?

Between the two extremes of maintaining full exposure and a major flight to safety are various responses employed by more tactical investors, whether institutional or individual. These groups can be heavily influenced by behavioural finance themes or seek to employ existing investment wisdom. While not identical in nature to responses to market events the appeal of the various approaches in factor investing are used heavily in these circumstances. Factor investing is an area primarily associated with quantitative fund management and sophisticated index algorithms but the two simplest techniques are following momentum trends and searching for value opportunities.

Following momentum trends means buying (or retaining) stocks or other underlyings that have shown strong growth and selling those that have performed poorly. In the context of an overall portfolio response this corresponds to staying long the market on the way up but reducing exposure on the way down. Value investing is more subtle as it is defined as taking positions in underlyings that are judged undervalued by some measure compared to the market price. On an individual basis this means focusing on companies or assets that have fallen out of favour but on a wider level the whole market can be judged undervalued after a big sell-off. It is interesting to note that these two popular themes are almost directly contradictory in that momentum followers favour selling after falls, whereas value investors would want to enter some targeted buying.

A tactical investor may judge that equities are fundamentally undervalued or that a short-term fall has been overdone and regardless of the motivation in both cases there will be a strong justification to enter the market at this time. This is sometimes known as “buying on the dip” - taking advantage of a recent market decline to buy at favourable levels in the expectation of a future rebound. Necessarily this concept and indeed its name implies that the investor knows that there will be what could be termed a dip, which suggests a fall followed by a rise. Future events may prove this to be wrong and that going into the market when is followed by immediate further falls - known colloquially as “trying to catch a falling knife”. The other scenario to be aware of is that the market may oscillate (stay range bound) for some time so that buying and selling the various mini highs and lows can get difficult and expensive.

However the appeal of buying into an asset after a fall is undeniable, and it is not only direct equity investors that can take advantage of this concept, it is also popular in structured products and is often employed by distributors looking to issue attractive products that benefit from market timing.

Better strike, better terms

As a recent example, the S&P-500 was at 4100 in mid-September 2022 but fell by over 10% in the following month to 3600. This situation may cause many investors to sit on the sidelines while markets slide but the money that is there to be invested is generally waiting for a favourable opportunity. After a correction of 10% if markets are looking more stable we can expect distributors to react quickly by issuing products and some investors taking this up. It is not simply the lower market entry levels that are more attractive because in general volatility levels will also rise during such an event. This was indeed seen recently with the VIX 1-year index increasing from 28% to 32% during this same period. A similar rise would be seen in implied volatility levels particularly in the shorter horizons of up to three years.

Therefore, the pricing of capital at risk products will also benefit. While not so automatic it is also often the case that equity falls are accompanied by (or caused by) rises in interest rate levels along the yield curve. This will benefit both capital at risk and capital protected products. These combined pricing benefits could passed be through into giving higher yields or more attractive protection levels such as a lower barrier.

A structured product “structured on the dip” will therefore benefit both from lower equity levels and more favourable pricing. For investors nervous of further falls even if they have made the decision to invest such a combination is very useful. For example, if a typical capital at risk structure previously had a 80% barrier but after an increase in volatility this could be lowered to 75% without reducing yield, the investor sees the “points” level of the barrier reduce from 3280 (80% of 4100) to 2700 (75% of 3600). This is a points reduction of some 18% giving significant extra comfort.

The investment horizon remains turbulent but structured products are an excellent tactical tool to take advantage of market movements when structured and distributed reactively and intelligently.