This article originally appeared on Investmentreview.com
Since the global credit crisis, investors have become more attuned to risk and portfolio volatility. And the investment industry has responded with a dizzying array of products and strategies designed to help manage unstable markets.
In response, advisors can help clients gain a clearer understanding of these products’ strategies, and can ensure they’re able to make informed assessments of their relative attractiveness.
Investors traditionally use de-risking and diversification to combat volatility, but they’re not the only available tools. There’s a wide array of alternative approaches, and they fall into three groups that can be described as:
- Changing the flavor of the equities we hold.
- Changing the shape of the return distribution we get from equities.
- Varying the exposure to equities over time, based on the current environment and market.
Changing the flavour: A defensive equity
Defensive stocks have historically delivered higher returns than the broader market.
Where there is a gain there is also a price, however. In the case of a defensive portfolio, this price lies primarily in tracking error, most notably in the sometimes-significant underperformance against the broad market when it is performing strongly.
The key point on which the case for defensive equity rests is these stocks are less attractive if judged by the standards of a traditional benchmark-relative investment mandate. The reason that risk may be attractively priced in this case, though, is the risk in question is more closely related to absolute volatility (to which traditional mandates pay no attention) than to tracking error.
Changing the shape: Options-based strategies
The price of an options contract is ultimately driven by supply and demand for insurance as measured by implied volatility.
The difference between implied and realized volatility can be thought of as an insurance risk premium. As with defensive equity, the price paid with call overwriting is tracking error. We can, however, be fairly sure as to how this tracking error will manifest itself over time.
Read: Inside covered calls
In bull markets, for instance, writing calls will lead to underperformance against the broad market. In bear markets, the premium capture will offset losses, leading to outperformance and smaller losses.
If judged by the standards of a traditional benchmark-relative investment mandate, call overwriting will seem unattractive. But if the objective is more closely related to managing absolute volatility, call overwriting allows an investor to capture this insurance risk premium: one that appears likely to persist in most market conditions.
Varying exposure: Volatility-responsive asset allocation
The decision to take risk implies a belief that risk will, in time, be rewarded.
There is no evidence that the reward for taking market risk is greater at times of elevated volatility, however. The notion that volatility can be forecast with more certainty than returns, and that returns, on average, are not materially different following periods of high or low volatility bring us to the idea of volatility-responsive asset allocation (VRAA).
Such a strategy would not have experienced as much variation in volatility as a traditional fixed-weight strategy. And this is due to increased exposure to equity—at the expense of low-risk assets—in stable times and reduced exposure in unstable times, while holding the same allocation to equity.
The cost of VRAA lies in its tracking error to a traditional mandate; while this approach appears to be quite effective in positioning a portfolio for different volatility regimes, it doesn’t offer protection against short-term shocks like the “flash crash” of 2010.
All of these strategies seek to reduce volatility by attempting to exploit different market effects. So, their return patterns are diversified and, in combination, they work well as tools to mitigate volatility.
For investors primarily focused on managing absolute volatility, a portfolio of multiple strategies can provide an attractive approach, which is complementary to more traditional risk-management approaches.
Greg Nordquist is director, Overlay Strategies with Russell Investments.