Despite negative perceptions, volatility can create opportunities for institutional investors.
By Andrew C. Smith, CFA, CAIA
Volatility. It's an important factor influencing portfolio returns, sometimes acting as a headwind for investors and other times as a tailwind. Volatility often has a negative connotation because of its association with uncertainty. Although it may sometimes make us uncomfortable, there are some simple things we can do to better manage volatility.
There are various ways to manage volatility, through rebalancing, strategy selection or employing a more nimble asset allocation.
The simplest approach to managing volatility is to regularly rebalance a portfolio to its strategic targets. This enables an investor to profit from reversing markets by selling at market peaks and buying on troughs while staying faithful to a long-term policy asset mix. In times of extreme stress, however, asset correlations may converge and rebalancing between investments where correlations have increased may have diminished impact. Re-examining how the policy asset mix is implemented can help.
For example, a portfolio’s equity exposure can be implemented either by selecting traditional strategies, which may become highly correlated during times of stress, or through a more diversified approach incorporating alternative strategies that employ a variety of different investment approaches. An example of this second option would be to supplement a traditional long-only equity strategy with a long/short equity strategy and a private equity strategy. In addition, introducing a high-quality dividend strategy could further mitigate volatility.
An international equity allocation can be implemented through a single manager, or alternatively through a diversified combination of strategies in a core/satellite approach. For example, using an index fund as a core strategy, investors can supplement the strategy with international long/short equity, international private equity, emerging market frontier and emerging market small-cap satellites. This approach may provide better diversification, lower correlation, and increased downside protection with a smoother return.
Some investors worry their long-term policy mix may not be nimble enough to handle market volatility. Adding a modest sized opportunistic bucket to a diversified portfolio may be a solution.
There are a number of tactical diversifying strategies to consider for an opportunistic bucket, including global tactical asset allocation, global macro hedge funds or managed futures. At the margin these strategies can reposition beta exposure and alter the volatility of the portfolio. Another way of making a portfolio more nimble, if investment policy permits, is via a tactical asset allocation overlay manager who synthetically alters the portfolio’s beta exposure using futures and/or ETFs.
In the face of ongoing volatility, investors may be tempted to de-risk a portfolio despite their concerns about missing out on a market rally. It’s important not to screen out volatility indiscriminately. After all, volatility can be an important component of returns.
Instead, endeavor to manage volatility smarter. Measuring your portfolio’s “pain ratio” — a concept developed by Zephyr StyleADVISOR to measure the ratio of a portfolio’s historical cumulative gains to losses — is one way to evaluate how well it handled volatility. To improve a portfolio’s pain ratio you may choose to test a number of strategies, including active rebalancing, diversification or opportunistic tactical allocation. The historical impact of those changes can be assessed by recalculating the pain ratio. Strategies that improved the ratio of a portfolios’ cumulative upside capture versus its downside capture would be reflected in an improved pain ratio.
It is possible to manage volatility better without abandoning long-term policy objectives. Managing better, however, does not necessarily mean eliminating volatility from your portfolio. Simple solutions like actively rebalancing, diversifying implementation options and considering more opportunistic strategies may help investors navigate through volatile markets.