Ladies and gentlemen, fasten your seatbelts. Current market volatility is expected to persist. From August to mid-September investors’ near-term expectations of equity volatility, as measured by the Chicago Board Options Exchange Vix index, was over double its average reading of June and July. It breached 40 five times, hitting levels not seen since early 2009.
So, that’s the bad news. The good news? Investment managers have various tactics to reduce negative effects of volatility on portfolios. They highlight diversification, derivatives and other ‘tail risk hedging’ to limit losses, absolute return funds and using lower-risk approaches to access risk-assets, such as convertibles for equity exposure.
Also, managers of low volatility portfolios note that ‘high risk’ does not mean ‘high returns’ – actually, quite the opposite is true. The importance of diversification is
often the first strategy mentioned.
Marais says multi-asset investing is a key way to dampen risk. “You are not hostage to the volatility of just one asset class, you have the flexibility to move between classes to provide downside risk protection, or seize opportunities. “
An unconstrained, multi-asset approach has been key to keeping volatility of the BNY Mellon Global Real Return fund at around 9% since launch in 2004, while returns averaged 12%, according to its manager Suzanne Hutchins.
DWS’s Hille advocates multi-asset approaches, but advises investors to select carefully. “The asset with the highest prediction of future returns is cash, and to get diversification in times of uncertainty it may play a key role. But it also has the lowest income, so only makes sense for a short period. Investors need to accept they will get lower returns if they want lower volatility on the other side.”
Hille’s multi-asset funds have cut equities to 5%, but he says any further rotation to Treasuries would not help any more from a risk budgeting perspective, because of T-Bills’ relatively high volatility.
Gold, another popular diversifier, “could hardly be defined as safe” at current levels, he says. Nor is it immune from sharp falls. From September 1980 to June 1982, for example, more than half its value evaporated.
Derivatives also play an important role in many managers reducing volatility. Hille generates part of his returns by writing then selling options, or limiting losses by
holding them. “If QE3 is instituted, you can see more massive snap-backs in assets, and the only way to avoid that is to go to cash, or have option trades that pay off if you have huge moves.”
But Hille and his peers are quick to point out potential pitfalls, too. “The problem with derivatives trades is, given volatility is high, they are very expensive at the moment. You need to have some sorts of options trades in your book to prevent too much pain,” he says.
“You need to buy convexity, long a call option, but buy it when the instruments are cheap, before volatility reaches elevated levels.”
DWS Investment’s inhouse models suggested early in July that macro slow-down and risk aversion were likely, so Hille could implement options-based strategies at acceptable levels. “You may have to give up some of your performance, but in the long run it can still pay off.”