Take The Long-Term View To Manage Volatility

By | May 9, 2016

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By Tom Lee, Managing Director, Investment Strategy and Research, Parametric Volatility today is not materially above the long-term average. If we use the CBOE Volatility Index as a reference, volatility since the end of 2015 averaged a little over 21 ½. Long-term VIX averages in the high 19s. The reality is people think we are in a higher-volatility environment because we came from, historically, a relatively low-volatility environment. Volatility tends to cluster into regimes. The volatility environment we’re in now is more normal. What caused volatility to elevate? There are a lot of contributors to volatility. There are the experimental and divergent monetary policies that are being pursued across the globe, including negative interest rates. And there’s also an intuitive understanding that the longer we are in this experimental monetary policy phase, the higher the risk is of some unintended consequence. We’re going to have this uncertainty for a while. Asset allocation Having said that, I don’t think that volatility should drive changes in asset allocation. Volatility tends to cluster in regimes and it would be very hard for an investor to time an upward or downward move. I think investors should structure their portfolios for the long term. I would say that now is a very prudent time for investors to closely observe their portfolio and make sure they have transparency into all the risks they’re taking and address unintended risks. As an example, recently investors have become very interested in hedging their currency exposure – after the strong rally in the dollar. They’re hedging only after they’ve experienced the risk. We are advocates of investors trying to get ahead of the curve with respect to risk. Investors need to show fortitude as volatility picks up and not overreact to events in the market. Staying the course What can investment managers do? First and foremost, investment managers can come up with ways that help the client to stick to their policy portfolio. So, as an example, they can offer seamless rebalancing methodologies. Investment managers can be more transparent about their strategies. By this I mean every strategy has periods when the wind is at its back and periods where you’re running into the wind. Overall it’s helpful to be more transparent about what environments will be challenging for a strategy. And if managers are forthright with the client about this, it’s less likely the client is going to terminate them during a challenging period. Frequently, in hindsight, we see that these challenging periods were absolutely the wrong time to terminate a strategy. Low-volatility strategies Low-volatility strategies are always worthy of consideration but investors need to be conscious of what they’re getting into. Most strategies are constructed around two general themes, a risk metric construction process and a min-variance process. Risk metric just involves sorting the index by various volatility metrics. Minimum variance looks beyond risk metrics and incorporates correlations among securities. All low-volatility factor construction uses some type of concentration limits. You need to understand that these strategies don’t outperform in every situation, namely a down market. For example, the S&P 500 Low [Volatility] Index has underperformed the S&P approximately 15% of the time when the market was negative. So investors have to understand that they can have these downward surprises. If investors want to avoid these types of surprises, either asset allocation or diversification through the introduction of other risk premiums will provide them with greater certainty of low volatility when they most want it, and that’s in a negative market environment. Holding cash In regard to holding cash, I think it’s challenging for an investor in the long term. They are holding risk assets to fund future liabilities, which are growing faster than cash. Investors holding cash also struggle to realize when the market is bottoming so they can time their move out of cash into risk assets. If you are really thinking about holding cash as a modest form of protection, there are other strategies available. A very simple one is a disciplined covered-call selling program that will generate cash in a stressful environment and dampen some of the downside volatility. That, to us, would be more prudent than parking money in cash. Derivatives Derivatives can and have been used to control portfolio volatility. Historically investors have used long puts or put spreads to control downside risk in portfolios. I am generally not an advocate of this approach. It needs to be highly customized to the particular investor and it can lead to a lot of challenging decisions. How do you pay for the downside protection? Do you sell away upside? Experience shows that most investors become fatigued with the expense and tend to terminate programs, often right before a market experiences challenges. Options An alternative approach is to sell fully collateralized options. This approach seeks to capture the volatility risk premium, which is embedded in options. It often makes more sense to de-risk the portfolio and consider being a seller, rather than a buyer of the hedge. The first adopters of this type of strategy were endowments and foundations. More recently there is increased interest from Taft-Hartley funds that are dealing with particular pension funds and mark-to-market issues, as well as public fund investors. There are benefits of selling volatility in a transparent, liquid and fully collateralized manner. One preferred way of doing that is through index options and trying to capture what academic and market research has identified as the volatility risk premium. The result is that this premium can be captured in a transparent, liquid manner and it shows diversification benefits versus traditional assets. It can have a material and positive impact on a portfolio over time. Focus on the long term Many investors look at volatility and are fearful. They intuitively understand that rising volatility generally means more stressful market environments. Investors need to take a step back and focus on the long term, and not become reactionary or fall into short-term pitfalls and try to shuffle their portfolio to follow some latest fad. As markets evolve there may be better approaches available to them that allow them to achieve their ultimate objectives. So be open to new ideas. There’s a lot of really creative thought going on right now in different areas that maybe in a couple years will become more mainstream. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. Scalper1 News

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