When choosing the type of fund to invest in, planners obviously must assess their clients’ risk profiles, their objectives and their financial position before deciding on which type of cat their fund manager should be trying to skin. We have recently been writing about volatility in markets and funds and reviewing various volatility strategies. We heard from some interesting speakers at our recent annual conference about ways to profit from volatility and improve risk-adjusted returns, and it is the volatility regime that we must also consider when choosing a time horizon for our investments.

If you have a mix of longer term, shorter term and medium term strategies in your portfolio, it is another way of achieving diversification and improving your chances of outperformance. After correctly assessing the prevailing volatility in the market, you can then select an appropriate time horizon and a fund suited to that time horizon and volatility. If you diversify your time horizon exposure, you are more likely to achieve better risk-adjusted returns over the long term.

Let’s consider first a rising volatility environment. Consider 2011, and in particular the third quarter. Just after this quarter ended, we started reviewing Australian equities managers. A very interesting dynamic had been playing out. Managers that happened to expose themselves to low volatility stocks and high yield stocks had performed very well. That is, they were less exposed to the downside volatility prevalent in the third quarter of 2011. We saw quality-biased value managers performing very well.

What was even more striking was the performance of some of the Market Neutral funds in 2011. Market neutral funds balance every long position with a short position, giving zero net market exposure. It seems that quantitative approaches that could harness short positions did extremely well as some of Australia’s better known industrial and consumer stocks “blew up” in 2011. In rising volatility environments, one might consider seeking such shorter time horizon investments. Cash will outperform in such an environment. Statistical Arbitrage strategies will most likely outperform. Market Neutral strategies did outperform, as did (as I have mentioned) low volatility equities strategies, M&A Arbitrage strategies and long short equities.

The common theme is that in markets with rising volatility, less exposure to market beta is better. If the beta of the fund is less than one, the volatility of that fund will be equal to or lower than the overall market volatility. When volatility rises, those types of funds generally outperform. Now consider a longer term horizon. You become less concerned with intra-year volatility and begin to focus on long term returns. You know that volatility reverts to the mean, so chances are that if volatility is very high this year, it will fall in the future.

In an environment of falling volatility, you can afford to lengthen your time horizon and seek longer-dated exposure to the market. We have observed that thematic strategies do well when volatility falls. Venture Capital approaches are also likely to prosper and those strategies will take some time to play out. Distressed debt strategies, exposure to the “value index” and equity long-only active management strategies are all likely to perform better amid falling volatility. If you had a method of predicting volatility, you could tailor your exposure to the right type of fund for the moment. Timing – or time horizon – would be everything.

However, if like myself, you do not have a volatility crystal ball, a possible approach would be to simply diversify your investments by time horizon. That is, you could invest in a thematic fund and an equities long-only growth fund (giving you a benefit from falling volatility) and combine this with market neutral funds, low volatility equities strategies and long short funds to take advantage of those times when volatility is rising.

Of course, this needs to be balanced with the risk profile of the investor and their investment objectives.

The post Consider diversifying investment terms to combat market volatility appeared first on AdviserVoice.