A fundamental approach to managing volatility

Ever since the Global Financial Crisis (GFC) of 2007-2009, investors have sought ways to avoid the high levels of market volatility experienced during those years. In this article, GSFM explores a number of strategies used to manage market volatility.

It’s with good reason that investors shy away from market volatility – the larger the drawdown a portfolio experiences, the more extreme the return needs to be on the upside just to get the portfolio back to where it started. An investor whose portfolio falls 10% needs to see a gain of roughly 11% to get back to his original starting point, but an investor whose portfolio falls 50% needs to see a 100% gain to restore that original loss.

If an investor can avoid large drawdowns, they don’t need to earn quite such heroic returns on the way back up – that’s the potential advantage of an investment strategy with low volatility.

Investment managers have responded to that demand, rolling out a variety of strategies labelled as ‘low volatility’ or ‘managed volatility’. But there are many ways to go about achieving lower volatility, and the portfolios that result from these different methods can look (and potentially behave) quite differently from each other. It is important for investors to understand those differences, but it is even more important for them to ask a fundamental question:

Are you better off investing in a fund that seeks low volatility as an investment strategy in and of itself, or a fund where low volatility is simply a consequence of the investment strategy, rather than being the strategy itself?

We will come back to this question, but to see why it matters, we first need to look at how managed volatility strategies work.

Managing portfolio volatility

There are many strategies for lowering portfolio volatility, but broadly speaking, they all fall into two basic categories: either you limit the portfolio to securities that you believe will have low volatility, or you allow the portfolio to invest in any stock and use some sort of tactical allocation strategy to lower the portfolio’s equity exposure in periods of higher volatility. Let’s examine each category in turn.

The first strategy — buying only stocks that you expect to have low volatility — is what some might call the smart beta approach. It treats volatility as a security-level characteristic, and screens for the securities that are expected to have the lowest volatility. While this approach can work, there are two drawbacks to it as well. The first is that predicting volatility at the security level is tricky. The most common method is to buy the stocks that have been the least volatile over some trailing time period (and to refresh the portfolio periodically based on updated data); this assumes that recent volatility patterns will persist for some length of time into the future. While sometimes true, this is not always the case.

A good recent example of a sudden dramatic change in volatility is the case of the energy stocks in 2014. As of 30 June 2014, energy stocks were the second-least volatile sector among the ten S&P 500 sector groups over the trailing twelve month period. However, during the third quarter of 2014, the price of oil began to drop and the volatility of energy stocks rose sharply. By 30 September their trailing twelve-month volatility ranked third among the ten sectors, and ten days later they were at the top of the list. Buying energy stocks in the middle of 2014 and expecting them to maintain the low volatility that they had experienced over the previous year would not have worked out well in the subsequent months.

A second drawback to the smart beta approach is that by screening on volatility at the stock level, you rule out large swathes of the market as potential investments, when what really matters in the end is the volatility of the portfolio, not of each underlying stock. Some individual stocks with high volatility may have relatively low correlation to the behavior of other stocks, such that holding those high volatility stocks in combination with other stocks may not raise the volatility of the portfolio by very much, if at all.

More importantly, though, the fact that a strategy would rule out holding large numbers of stocks based on their volatility alone raises the question we alluded to earlier: is volatility in and of itself really what you want to structure your investment process around?

The second category of low volatility strategy is to use a tactical allocation methodology to raise and lower a portfolio’s equity exposure in response to changes in market volatility. This avoids the problem of ruling out stocks based solely on their individual volatility. You can apply a tactical volatility management overlay to any underlying investment strategy. These strategies generally use some form of rules-based approach, reducing equity exposure in some predetermined way when market volatility rises, and raising it when market volatility falls. So you are free to invest in whatever stocks you want within the portfolio, regardless of their volatility, because the overlay strategy will take care of managing the portfolio’s volatility.

A fundamental approach

As an alternative, investors who interested in low volatility could source investments that focus on investment fundamentals first, but which do so in such a way that low volatility is a consequence of the strategy, rather than its primary goal.

For example, a Shareholder Yield strategy is one that does not specifically aim to achieve lower volatility than the market, but lower volatility is a byproduct of the investment process.

The approach sets out to achieve an attractive real return, gathered from the most reliable components of the return that is available through equities: growth in free cash flow, cash dividends, and stock buybacks and debt reduction. In assembling the portfolio, holdings are constrained around those factors; that is, no particular stock is overly important to the portfolio’s growth or its income generation. Each portfolio holds close to 100 stocks, which provides diversification.

The returns and lower volatility of the Shareholder Yield strategies make sense in the context of the past behavior of dividend-paying stocks (Figure 1). In the long run, companies paying stable or growing dividends have shown the best returns, as well as lower volatility.

 

 

Having the right goal is important. There is nothing inherently wrong with wanting to experience lower volatility in an investment portfolio; a strategy such as a Shareholder Yield strategy can achieve lower volatility while still aiming for a fundamentally sound investment goal.

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This article provides general information only and has been prepared without taking account the objectives, financial situation or needs of individuals. The information contained in this article reflects, as of the date of publication, the views of Grant Samuel Funds Management Pty Limited ABN 14 125 715 004 AFSL 317587 (GSFM) and sources believed by GSFM to be reliable. We do not represent that this information is accurate and com­plete, and it should not be relied upon as such. Any opinions expressed in this material reflect our judgment at this date, are subject to change and should not be relied upon as the basis of your investment decisions. All reasonable care has been taken in producing the information set out in this article however subsequent changes in circumstances may occur at any time and may impact on the accuracy of the information. Neither GSFM, its related bodies nor associates gives any warranty nor makes any representation nor accepts responsibility for the accuracy or completeness of the information contained in this article. Past performance is not a reliable indicator of future performance. Investing involves risk including loss of capital invested. ©2016 Grant Samuel Fund Services Limited.