The industry tends to focus on return forecasting as a way to maximize returns. But there’s a better approach, argues Sebastien Page, co-head of the asset allocation group at T. Rowe Price in Baltimore, Ma.
Read: How to trade volatility
“Risk-based investing offers tools that can more easily and in a more robust way improve portfolio performance,” he said at the CFA Institute’s 69th Annual Conference in Montreal. (Follow our live tweets from the conference here.)
He suggests two approaches to risk-based investing.
1. Managed volatility
This method is focused on “reducing drawdown exposure by de-risking the portfolio when volatility is high,” says Page. He notes high volatility tends to lead to more high volatility—what’s usually referred to as persistence in risk. “Managed volatility seeks to smooth the ride for investors. If you have a constant allocation [to] stocks and bonds, you truly don’t have a constant risk exposure.”
Page says if you look at the rolling one-year volatility of a 60%/40% mix, it varies between 5% and 20% over the past 15 years. Rolling 3-year volatility varies between 5% and 16%.
This shows, suggests Page, that a constant, strategic mix does not equate to a constant level of risk. He says managed volatility is similar to how pilots react when they hit turbulence: they change altitude. “[It] ultimately leads to a lower exposure to loss.”
Interest-rate and stock futures are the main tools for implementing this method.
2. Volatility risk premium
Page says the “volatility risk premium represents compensation for negative skewness/providing insurance to market participants.” This approach is implemented via covered call writing.
“The correlation between these two approaches is negative,” adds Page. “It’s also negative with the stock market. You get a nice portfolio effect when you combine these tools.”
Page says you can use these methods in one of two ways. One way is to carve out a portion of the portfolio (5% to 10%) and devote it to either or both strategies. “The other way is to scale the positions all the way to the entire value of the portfolio. So you change the volatility and return profile of the entire portfolio as opposed to just within a sleeve.”
Page adds that using managed volatility and the volatility risk premium together is ideal because “managed volatility tends to do well when the volatility risk premium doesn’t do as well.”