Reducing Volatility in Turbulent Times

The past 10 years reminded investors of just how volatile markets can behave. The decade witnessed two drops in the S&P 500 in excess of 40%, corporate bonds severely underperforming government bonds in 2008 before strongly outperforming in 2009, and commodities experiencing wide price ranges illustrated by oil prices hitting highs of $140 and testing lows in the $30s.

Many categorize the past 10 years as a “lost decade” and some challenge the merits of asset allocation and equity investing in general. As worries over the sustainability of an economic recovery are fueled by both media headlines and investors’ reactions to seesawing economic indicators, it would seem that heightened volatility is here for the foreseeable future.

We hear investors asking if they have to accept high levels of volatility to achieve the returns they desire and if not, how they can construct a portfolio with lower volatility. The practice of predicting volatility tends to be futile and recent market swings have only reinforced that notion. What matters is not the volatility itself, but rather how an investor reacts to the volatility.

The importance of reducing the effect of negative returns within a portfolio is a matter of both math and psychology. Illustrated by the chart below, the relationship between losses and recovering from those losses is not linear. Simply put, it is exponentially more difficult to recover from larger losses than it is to recover from smaller losses. In dollar terms, more consistency and minimizing losses equates to more wealth.

Making It Up: Returns Needed to Recoup Losses in a Portfolio
Reprinted from "Carpet Balming," by Mike Patton, 2010, Investment Advisor. 5 May 2010

From a psychological standpoint, many investors let emotion drive their decision making and tend to abandon their investment plan in the face of losses. This was the case in early 2009 when investors fled equities and missed out on the impressive recovery in the equity markets which began in March of 2009. Those who waited for the recovery to gain more solid footing and reinvested in early 2010 experienced significant volatility in spite of the apparent recovery.

Prudent advisors advocate that investors need to develop and implement investment strategies based on their unique goals, needs, time horizons and risk tolerance. All investments fall on a risk spectrum and at any point in time, equity investments will inherently carry more risk than bonds and bonds will inherently carry more risk than cash. The additional risk associated with equities is why investors have been historically rewarded with higher relative returns. We believe investors’ exposure to equities and the types of equity strategies chosen should be based on a combination of the investor’s need for growth in the portfolio and their tolerance for volatility.

How can one build an effective portfolio when buying equities feels like riding a never ending roller coaster? There are several ways to pursue the objectives of lowering volatility and growing a portfolio.

First, formalize and adhere to a strategic asset allocation aligned with your goals and objectives. Having a disciplined approach to rebalancing forces an investor to sell high (trimming outperforming asset classes) and buy low (adding to underperforming asset classes). Rebalancing can be periodic or more active based on thresholds or the utilization of cash flows (dividends, interest or additional investment) into the portfolio. Investors may also reallocate among asset classes if they feel they do not need to take as much risk (reducing overall equity exposure). The latter is a wealth management approach and keeps the portfolio aligned with one’s goals.

Second, a vital component of developing a strategic asset allocation is incorporating low-correlation assets. To fulfill different areas of the strategic asset allocation, an investor will seek strategies that move or react differently at different stages of the market cycle. These can be style (growth/value), size (large, small, micro-cap), sector and country (domestic/international) among others. The concept is simple to explain and works fine unless risk changes. In 2008 this proved not a failsafe plan. Correlation is a moving target and when all asset classes moved towards a correlation of nearly one (perfect correlation), investors found there were few equity investments that provided a safe haven. Although investors who held more fixed income and cash were cushioned, diversification among equities did not dampen volatility as one would expect or hope.

When discussing low volatility strategies, the focus should be on the variation of returns versus full equity benchmarks such as the S&P 500 or Russell 1000. We consider strategies to have lower volatility if their beta is less than one. For example, a beta of .75 means the strategy has exhibited returns which are about 25% less volatile than the benchmark.

Third, an investor can introduce hedged or lower volatility equity strategies to the portfolio. The inclusion of lower volatility strategies as a core holding in a portfolio may reduce the effects of large market swings. Because uncertainty and risks always exist, a combined asset allocation approach, disciplined rebalancing and lower volatility equity strategies provide an investor the most likely opportunity to stick to his/her plan and achieve his/her goals.

Due to the lock-ups, illiquidity, high minimums, lack of transparency and scandals involving hedge funds, many investors are hesitant to invest in hedged or alternative strategies. However, investors can now access long-short, market-neutral, convertible, and merger and acquisition strategies as well as managed futures and option strategies, in both mutual fund and exchange-traded fund (ETF) structures. These publicly traded vehicles offer greater transparency, liquidity and, most importantly, potential low correlation/low beta returns versus broad market indices. These lower volatility strategies can offer investors time in the market (a full market cycle) and a comfort level that neither long only stocks nor bonds alone can provide. Most of these strategies seek to contain equity risk while eliminating market timing activities. Managers will stay fully invested and use a range of sophisticated risk management strategies and tools to maintain a consistent, acceptable risk posture. This allows the strategy to capture much of the market upside while providing downside protection as well. Strategies are most often actively managed in order to respond to the rapidly changing investment landscape.

And finally, when significant downside volatility does occur, investors should do their best to avoid significant draws from a portfolio. The best way to achieve the returns necessary to recover from a significant drop in the market is to stay invested. The most dramatic market returns typically occur early in the recovery, and investors who miss the upswing find themselves at a significant disadvantage. Reallocation to less volatile strategies may be appropriate for many investors, but retaining market exposure is critical to a portfolio’s recovery.

Two of the most significant causes for draws are psychological reactions to the volatility and income taxes. Significant declines in the markets often cause investors to sell out, reducing their exposure to the markets. When they sell, the investors may not feel like they made money, but they often recognize significant taxable gains on securities that have been held for long periods of time. The unexpected tax bill that follows often causes further withdrawal from the markets. Proper tax planning is critical when investors are adjusting their allocations, even in the face of volatility, to avoid further damage to a portfolio from unexpected tax liabilities.

In conclusion, risk, volatility and uncertainty are going to be a perpetual part of the investment landscape. Currently, risk and volatility are more pronounced than they were just a few short years ago and perhaps more than at any time since the 1930s. It is increasingly important for investors to have a well-articulated and formalized investment policy in place as well as a prudent process for rebalancing. Investors can further look to reduce volatility by incorporating low volatility/low beta strategies within the portfolio. More consistent returns can potentially lead to higher, long-term returns and increased wealth. This overall wealth management approach should allow an investor to stick to an appropriate plan through turbulent times and ultimately allow them to achieve their most important goals and objectives.