Since the global credit crisis, investors have become more attuned to risk in general and to portfolio volatility in particular. The investment industry has responded with a dizzying array of products and strategies designed to help manage volatility. A clearer understanding of these sources of volatility reduction can mean that investors are better placed to make informed assessments of their relative attractiveness.
De-risking and diversification are traditionally used by institutional investors to manage volatility. They are well understood and remain appropriate tools. They are not, however, the only tools. Indeed, there are a wide array of alternative approaches to managing the volatility associated with equity exposure. These fall into three groups that can be broadly 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 environment we are in.
Each of these is described below.
Changing the flavor: defensive equity
Defensive stocks have historically delivered higher returns than the broader market. However, where there is a gain there is also a price. 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 that 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 is that 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. In bull markets, writing calls will lead to underperformance against the broad market. In bear markets the premium capture will offset losses, leading to outperformance (i.e., smaller losses). Again, if judged by the standards of a traditional benchmark-relative investment mandate, call overwriting will be unattractive. If instead 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 the exposure: volatility-responsive asset allocation (VRAA)
In itself, the decision to take risk implies a belief that risk will, in time, be rewarded. However, there is no evidence that the reward for taking market risk is greater at times of elevated volatility. 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 VRAA. Such a strategy would not have experienced as much variation in volatility as a traditional fixed-weight strategy. 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, on average, the same allocation to equity. Just as with the other two strategies discussed above, the cost of VRAA lies in its tracking error to a traditional mandate. Also, while this approach appears to be quite effective in positioning a portfolio for different volatility regimes, it does not offer protection against short-term shocks such as occurred in October 1987 or in the “flash crash” of 2010.
A portfolio of volatility-management strategies
While all of the strategies described above seek to reduce volatility, they do so by attempting to exploit different market effects. Consequently, their return patterns are diversified and, in combination, they work well as tools to mitigate volatility. The focus of many investors has shifted in recent years, and the solutions presented here offer an upside/downside trade-off consistent with evolving investor preferences. For investors primarily focused on managing absolute volatility, a portfolio of multiple strategies can provide an attractive approach that is complementary to the traditional risk-management approaches of de-risking and diversification.
Greg Nordquist is director, Overlay Strategies with Russell Investments.