At these volatility levels, our nominal strategy positioning will likely still be materially underweight equity into May. Across our strategies, volatility has to return to the neighborhood of 20% before our model allocations will be targeting “neutral” equity exposure (e.g. 60% for Dynamic Managed Volatility, 80% for Managed Volatility Equity). Given the truly massive Federal monetary and fiscal intervention in the market, we will continue to carry options-based long equity proxies across strategies to at least partially participate in any short-term market gains, however unwarranted they may be.
For example, we are carrying 4% notional coverage in VIX puts, spread across two strikes and expiries. These were purchased as one such long equity proxy, when the VIX was near its recent peak. Our strategies are also carrying May expiry S&P 500 call spreads, 2300-2455 strike, 10% notional. We anticipate replacing this option exposure with linear exposure as volatility subsides.
One final point regarding portfolio diversification; both investment grade and high yield spreads are at, or near, record one-month volatility and three-month correlation with the S&P 500. Even with the Fed stepping into the market with outright purchases of wide swaths of the investment grade universe, we still expect these metrics to remain elevated until the full economic impact of the coronavirus is understood. In the interim, corporate fixed income may not provide as much portfolio diversification as intended, given the current extreme correlation with equity, and general spread volatility. Rather than rely on fixed income as a risk diversifier, we continue to view risk management embedded in the equity portion of investors’ portfolios as the appropriate choice.