Castle with clear blue skies

Playing a Defensive Game

March 2016


Equity investors have faced a difficult start to the year. All major equity markets are down, and volatility has continued to rise.

Equity investors have faced a difficult start to the year. All major equity markets are down, and volatility has continued to rise. A convergence of investor concerns is likely to dominate markets for the near term — with consequences for strategies seeking to generate alpha through stock picking.

The same economic and policy issues continue to dominate markets. Emerging market weakness is spilling over to developed markets, and China and oil are dominating sentiment. Uncertainty over the impact of the recent hike in US rates, and the likely path for future monetary policy, does not help matters. A notable development in the new year has been an apparent shift in the significance of central bank rhetoric: monetary policy has been a clear driver behind investor sentiment since the global financial crisis.

However, while many central bankers issued dovish statements as markets fell in January, their impact on market performance has been muted thus far. Even the Bank of Japan’s historic decision to introduce negative interest rates only briefly led to a rally in Japanese stocks, as concerns over the longer-term impact of negative rates took hold. It appears that the markets’ faith in the ability of central banks to generate growth and return inflation to targeted levels might be fading.

The impact of these macro factors is worse for some areas than others. As China continues to slow, global GDP growth is reducing, but this has limited immediate implications for economic growth in the UK and Europe. The profit impact for quoted companies is likely to be worse, but depends on their exposure to slowing markets and is mainly felt through weaker currencies. While earnings will likely remain under pressure, the outlook for Main Street could be more benign.

The role of banks will be pivotal, and at the moment we take comfort from their stronger balance sheets, set against the likelihood of events that are unlikely to match the global financial crisis for size.

In the UK, the debate over the potential departure from the European Union is dominating headlines and will only encourage investors to be cautious. The consumer could hardly be described as exuberant. It has been somewhat disappointing that fuel price weakness has not led to better conditions thus far, but it should continue to provide a cushion against a further erosion in consumer confidence. For now, it appears there will be little reason for corporations and consumers to change their behaviour unless they run out of financing.

Aside from the implications of broad macro issues, technical factors are also having an impact. Elevated volatility and outflows have led hedge funds and other active managers to reduce or close positions causing some unusual stock price movements which appear at odds with fundamentals. Investors are also using equities to hedge exposures in other asset classes such as credit. The falling oil price is squeezing investors who have historically depended on oil to fund expenditures, such as sovereign wealth funds, leading to asset sales elsewhere — including equity markets.

It is possible for long/short strategies to profit in volatile environments, but in the face of the current short-term uncertainty we have adopted an increasingly defensive stance. In our portfolios we generally have two ways to control exposure: namely, adjusting hedges and position sizes/ gross exposure.

The ability to adjust hedges is a result of our investment approach, which depends on pair trades. After identifying a lead long or short investment, we select a hedge to isolate the specific risks that we wish to target, while seeking to minimize market direction and other unwanted risks. Typical hedges include a broad market index, an index that tracks a specific sector, or specific stocks. We have the flexibility to“tighten” or “loosen” a hedge within a pair trade as market conditions evolve: for example, an index hedge can be “tightened” to a sector instrument, or similar stocks, with an aim to reducing industry risks as well as broad market direction risk.

As macro uncertainty picked up over 2015, we tightened the hedges within our portfolios, generally opting for sector instruments (such as a retail stock index rather than a broad stock index) and stock-specific hedges to limit market exposure.

More recently, heightened volatility and uncertainty has also led us to reduce overall gross exposure in our portfolios. Gross exposure is currently at the bottom of the historical range, post-financial crisis, in our portfolios.

We are currently in the eye of the storm. We believe volatility is likely to continue until the outlook for China and global growth stabilises. It is also possible that further developments, such as another shift in central bank policy, could serve to either dampen volatility or sustain it.

Periods of market stress typically throw up opportunities as some prices move too far, or anomalies are created. Having reduced gross exposure in our portfolios we have capital to deploy as the environment stabilizes.

Playing a Defensive Game Chart

Insight Investment is the corporate brand for the group of companies managed or administered by Insight Investment Management Limited which includes Insight Investment Management (Global) Limited, Pareto Investment Management Limited, Insight Investment Funds Management Limited, Cutwater Investor Services Corporation (CISC) and Cutwater Asset Management Corporation (CAMC). CISC and CAMC are owned by BNY Mellon and operated by Insight.

BNY Mellon Investment Management is one of the world’s leading investment management organizations and one of the top U.S. wealth managers, with $1.6 trillion in assets under management. It encompasses BNY Mellon’s affiliated investment management firms, wealth management services and global distribution companies, including the Dreyfus Corporation, Insight Investment and MBSC Securities Corporation. Dreyfus and Insight are affiliates. BNY Mellon is the corporate brand of The Bank of New York Mellon Corporation. MBSC Securities Corporation is a registered broker-dealer, a member of FINRA and an indirect wholly owned subsidiary of BNY Mellon.

This information is not investment advice, though may be deemed a financial promotion in non-U.S. jurisdictions. Accordingly, where used or distributed in any non-U.S. jurisdiction, the information provided is for Professional Clients only. This information is not for onward distribution to, or to be relied upon by Retail Clients.

For marketing purposes only. Any statements and opinions expressed are as at the date of publication, are subject to change as economic and market conditions dictate, and do not necessarily represent the views of BNY Mellon or any of its affiliates. The information has been provided as a general market commentary only and does not constitute legal, tax, accounting, other professional counsel or investment advice, is not predictive of future performance, and should not be construed as an offer to sell or a solicitation to buy any security or make an offer where otherwise unlawful.

The information has been provided without taking into account the investment objective, financial situation or needs of any particular person. BNY Mellon and its affiliates are not responsible for any subsequent investment advice given based on the information supplied. This is not investment research or a research recommendation for regulatory purposes as it does not constitute substantive research or analysis. To the extent that these materials contain statements about future performance, such statements are forward looking and are subject to a number of risks and uncertainties. Information and opinions presented have been obtained or derived from sources which BNY Mellon believed to be reliable, but BNY Mellon makes no representation to its accuracy and completeness. BNY Mellon accepts no liability for loss arising from use of this material. If nothing is indicated to the contrary, all figures are unaudited.

Any indication of past performance is not a guide to future performance. The value of investments can fall as well as rise, so investors may get back less than originally invested. Not for distribution to, or use by, any person or entity in any jurisdiction or country in which such distribution or use would be contrary to local law or regulation. This information may not be distributed or used for the purpose of offers or solicitations in any jurisdiction or in any circumstances in which such offers or solicitations are unlawful or not authorized, or where there would be, by virtue of such distribution, new or additional registration requirements. Persons into whose possession this information comes are required to inform themselves about and to observe any restrictions that apply to the distribution of this information in their jurisdiction. This information should not be published in hard copy, electronic form, via the web or in any other medium accessible to the public, unless authorized by BNY Mellon Investment Management.

This information is approved for Global distribution and is issued in the following jurisdictions by the named local entities or divisions: Europe, Middle East, Africa and Latin America (excl. Switzerland, Brazil, Dubai): BNY Mellon Investment Management EMEA Limited, BNY Mellon Centre, 160 Queen Victoria Street, London EC4V 4LA. Registered in England No. 1118580. Authorised and regulated by the Financial Conduct Authority. • Switzerland: Issued by BNY Mellon Investments Switzerland GmbH, Talacker 29, CH-8001 Zürich, Switzerland. Authorised and regulated by the FINMA. • Dubai, United Arab Emirates: Dubai branch of The Bank of New York Mellon, which is regulated by the Dubai Financial Services Authority. This material is intended for Professional Clients only and no other person should act upon it.• Singapore: BNY Mellon Investment Management Singapore Pte. Limited Co. Reg. 201230427E. Regulated by the Monetary Authority of Singapore. • Hong Kong: BNY Mellon Investment Management Hong Kong Limited.

Regulated by the Hong Kong Securities and Futures Commission. • Japan: BNY Mellon Asset Management Japan Limited. BNY Mellon Asset Management Japan Limited is a Financial Instruments Business Operator with license no 406 (Kinsho) at the Commissioner of Kanto Local Finance Bureau and is a Member of the Investment Trusts Association, Japan and Japan Securities Investment Advisers Association. • Australia: BNY Mellon Investment Management Australia Ltd (ABN 56 102 482 815, AFS License No. 227865). Authorized and regulated by the Australian Securities & Investments Commission. • United States: BNY Mellon Investment Management. • Canada: Securities are offered through BNY Mellon Asset Management Canada Ltd., registered as a Portfolio Manager and Exempt Market Dealer in all provinces and territories of Canada, and as an Investment Fund Manager and Commodity Trading Manager in Ontario. • Brazil: this document is issued by ARX Investimentos Ltda., Av. Borges de Medeiros, 633, 4th floor, Rio de Janeiro, RJ, Brazil, CEP 22430-041. Authorized and regulated by the Brazilian Securities and Exchange Commission (CVM).

The issuing entities above are BNY Mellon entities ultimately owned by The Bank of New York Mellon Corporation.

BNY Mellon Investment Management EMEA Limited ("BNYMIM EMEA") is the distributor of the capabilities of its investment managers in Europe, Middle East, Africa and Latin America. Investment managers are appointed by BNYMIM EMEA or affiliated fund operating companies to undertake portfolio management services in respect of the products and services provided by BNYMIM EMEA or the fund operating companies. These products and services are governed by bilateral contracts entered into by BNYMIM EMEA and its clients or by the Prospectus and associated documents related to the funds.

BNY Mellon Cash Investment Strategies is a division of The Dreyfus Corporation. • BNY Mellon owns 90% of The Boston Company Asset Management, LLC and the remainder is owned by employees of the firm. • The Newton Group ("Newton") is comprised of the following affiliated companies: Newton Investment Management Limited, Newton Capital Management Limited (NCM Ltd), Newton Capital Management LLC (NCM LLC), NCM LLC personnel are supervised persons of NCM Ltd and NCM LLC does not provide investment advice, all of which is conducted by NCM Ltd. Only NCM LLC and NCM Ltd offer services in the U.S.• BNY Mellon owns a 20% interest in Siguler Guff & Company, LP and certain related entities (including Siguler Guff Advisers LLC).

For Use with Financial Professionals Only. Not for Use with the General Public.

© 2016 MBSC Securities Corporation