“Embrace the chaos.”
(Quote attributed to Friedrich Nietzche, famous 19th century German philosopher)
By Scott Welch, CIMA®, CEPA®, Chief Investment Officer & Partner
Reviewed by Carter Mecham, CMA®, IACCP®
We posted a blog last September entitled “Portfolio Construction in a VUCA World.”
We make no claims to being more prescient than anyone else, but that blog turned out to be timely. We are now at war, and anyone who tells you how it will work out is either naïve or lying to you.
So, let’s review what we mean by portfolio construction in a VUCA world, and then translate that into investment advice in the current market environment.
The term “VUCA” has been around since the 1980s and was introduced by management and leadership experts Warren Bennis and Burt Nanus in their book Leadership: The Strategies for Taking Charge. [1]
The initial application was for the US Army as it recognized the need to change its approach to defensive readiness after the fall of the Berlin Wall. The belief was that this would usher in an increasingly chaotic geopolitical world, and the Army needed to adapt and adjust accordingly.
So, what does VUCA stand for and, in the context of investing and portfolio management, what does it suggest?
Returning to a VUCA World
The term VUCA stands for:
- Volatility: The concept that change is no longer gradual – it can be sudden and explosive. We certainly witness this on a regular basis in the global geopolitical and capital markets. The beginning of the Iranian war certainly falls in the “volatile” category.
- Uncertainty: Traditional forecasting proves be increasingly unreliable. We operate in increasingly unpredictable global markets, not to mention national and geopolitical tensions.
- Complexity: Historically, straightforward relationships seem to be fading away, and we increasingly operate in a market of complex interdependence and continual innovation. One needs to look no further to see this than the application of artificial intelligence to the broad economy – including wealth management (still in its early days, but with exponential growth expectations).
- Ambiguity: It seems that in the investing world, very few things are black and white anymore. We live in a world of gray where clear answers often don’t exist.
Source: Adapted from “Entrepreneurial Mindset in the VUCA World” by Merve Erbeck, 2022.
For most of the past 10-15 years, many investors lived in a very “un-VUCA” world – interest rates were low, equity market volatility was almost non-existent, and investing seemed fairly simple – just “buy the index and ride the beta wave.”
Anyone who deviated from this approach was often accused of “deworsifying” their portfolios. It often appeared that traditional portfolio management approaches – asset allocation, diversification, portfolio optimization, and so forth – were no longer applicable and “this time it was different.”
But that expression has proven to never be true. Fundamental investment principles exist for a reason – because historically, they work over any reasonable time horizon.
We believe we are entering a new market regime, with increased volatility and uncertainty. In this evolving environment, we believe fundamental investment principles will once again matter. If we are correct, how might we respond to what may be an increasingly “VUCA-like” market?
Using Positive VUCA in Portfolio Construction
Several years ago, we were introduced to a potential investment response to a VUCA market environment – let’s call it “Positive VUCA”:
- Vision: The ability to see the market environment clearly, based on facts and not clouded by biases or pre-judgment. In other words, doing our best to separate market “noise” from market “signals.” We by no means minimize the potential danger and tragedy of the current war – we’ve lived through too many of them. But should it prove to be short(ish) and the US/Israel alliance “wins,” the war is likely to be viewed more as “noise” than a “signal” for fundamental shifts in investment philosophy.
- Understanding: Being aware of and informed about the choices and options that are available to us to meet current market environments and specific client needs and objectives.
- Clarity: Having a clear, consistent, and defensible investment philosophy and portfolio construction approach.
- Agility or Adaptability: The ability to pivot or evolve as market conditions change, without losing sight of our core investment philosophy.
Source: Adapted from Dreamstime.com
How might we translate “Positive VUCA” into a portfolio construction philosophy, especially in the current market/ war environment?
Let’s begin by reminding ourselves of the concept of “economic regime investing” and attempting to build “all-weather” portfolios.
The phrase “all-weather” refers to building portfolios that have the potential to generate consistent performance regardless of the underlying economic and market regimes.
The simple schematic below illustrates the four primary phases of the economic cycle, based on whether the economy and inflation are increasing or decreasing.
We can then overlay this schematic with which types of investment strategies have the potential to perform best during which phase of the economic cycle.
Definitions: “Capital Growth” = Equity strategies, “Income” = Rate and Credit strategies, “Real Assets” = commodities, precious metals, real estate, infrastructure, MLPs, etc., “Volatility Management” = alternative and private investment strategies. For illustration purposes only – does not represent investment advice.
We believe this is an appropriate “Positive VUCA” response to the current VUCA-like market environment.
We suggest that a diversified portfolio that includes all four primary investment categories – capital growth, income, real assets, and volatility management – remains the correct response to today’s market environment (and, in fact, most market environments) and our model portfolios are allocated accordingly.
This is nothing new. In fact, it represents somewhat of a “back to the future” approach. It suggests that constructing Defensible, Understandable, Resilient, and Flexible portfolios is a logical way to manage and mitigate VUCA, including in a war environment.
This does not lend itself to a catchy acronym (DURF? Umm…no) but it does capture an appropriate and intelligent portfolio construction approach.
Put differently, this Positive VUCA portfolio would be characterized by:
- Global diversification across traditional long-only asset classes (stocks, bonds, and real assets)
- A reasonable time horizon (5-7 years), or what we like to refer to as the “turn off your TV and take your dog for a walk” market mentality
- The intelligent allocation to both active and passive investment strategies, to optimize fees and taxes, and
- The prudent use of both alternative and private market investments to potentially achieve better diversification and higher risk-adjusted return.
Most threats to any system, environment, or market offer equal and opposite opportunities.
In this case, the potential threat is characterized by what we believe will be a market of increased volatility, uncertainty, complexity, and ambiguity. That is, VUCA.
Summary & Interpretation
As we write this, the markets have reacted to the war as we might expect – flights to quality and a “risk off” mentality.
However, as has been the case for much of the past 2-3 years, the market seems to be remarkably complacent, given that the US and Israel are at war with a primary Middle East adversary.
Yes, the dollar has gotten stronger, US Treasuries rallied (and then gave it back and yields have trended upward as the fear of inflation has crept back in), US stocks have not overreacted, gold has rallied, and so forth.
Non-US equity markets have taken the biggest hit, given that they are far more dependent on Middle East oil than the US is, and the Strait of Hormuz – a narrow passage through which roughly 20% of the world’s oil supply is transported – is directly in the field of battle and therefore remains a bottleneck on the current flow of oil and therefore the global economy.
In our opinion, this somewhat remarkable complacency comes down to an underlying assumption that the war will not last long and that the US and Israel will “win.” But the “fog of war” is real, and it is way too soon to predict an outcome.
The opportunity is that this seems to be an ideal time to get in front of investors and explain to them why this “Positive VUCA” investment approach makes sense. It has vision, understanding, clarity, and adaptability.
This “all-weather” approach, we believe, represents the best potential opportunity to deliver consistent performance over time, regardless of market regime.
We are strategic investors and recommend that investors not overreact until and unless we have better clarity on how things may shake out. And, even then, if you are already well-diversified, the best course of action is the World War II British slogan – “Stay Calm and Carry On.” For those of a more religious bent – “This, too, shall pass.”
As always, we welcome your questions and feedback.
[1] Leaders The Strategies for Taking Charge: Warren Bennis & Burt Nanus: 9780060913366: Amazon.com: Books