The key points are as follows:

• After strong gains shares were due for a correction. Worries about the Fed, Japan, China and the growth outlook in Australia have provided the trigger. 
• However, with Fed tightening fears overdone, the US economy on a sounder footing, Japan looking stronger, China likely to grow around 7.5% and the Australian economy to benefit from low interest rates and a lower $A, a re-run of the 15 to 20% falls seen around mid 2010 and mid 2011 are unlikely.
• Our cyclical view for shares remains positive, with further gains likely this year. We remain of the view that by year end the ASX 200 will end around 5250.

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Therefore, innovation is essential in exploring new ways of investing and managing assets through this extended period of economic uncertainty.
 
The report, titled Innovation in the Age of Volatility, is a US follow-up to Market Volatility: Friend or Foe?, the global report released June 25, 2012. It surveys 289 respondents including asset managers, pension plans, pension consultants and fund distributors from 29 countries with combined assets under management totaling more than $25 trillion. The survey was followed by 100 interviews.
 
“In the wake of the 2008 credit crisis, prolonged volatility has enjoined investors and their managers alike to explore new ways of investing and managing the asset business to cope with the new reality,” said Prof. Amin Rajan, CEO of CREATE-Research and the report’s author. “The conventional wisdom has been severely tested and a new approach is duly emerging. Now, success is about understanding the dynamics of price dislocations and devising appropriate strategies for different volatility regimes.”
 
Major findings of the report include:
Market volatility will persist and be driven by politics and policy decisions more so than economic fundamentals.

Smart investing is no longer about diversification across style boxes or indices. Opportunism trumps diversification.

Investment choices will blend opportunism with caution, and professional asset allocation skills will be in demand. Investors recognize they do not have the skills necessary to capitalize on opportunities created by volatility in the markets. These trends will fuel flows into target-date and target-risk funds.

Income in retirement products will focus on replacement of income earned in employment as fewer and fewer individuals receive defined-benefit-style pensions. Target-date funds especially will see significant innovation, as they will have a retirement income benchmark similar to liabilities in defined-benefit plans. And innovation in portfolio risk management is abundant and moving away from diversification across style boxes as a focus.

Innovation in the business models for asset managers will center around the need to become a trusted advisor to clients as products are increasingly outcome-oriented and customized.

“These are exciting—but challenging—times for asset managers as the landscape continues to change rapidly. As markets remain volatile, investors no longer care about benchmarks and instead want to focus on particular outcomes,” said Barb McKenzie, chief operating officer of Principal Global Investors.
 
“Asset management talent who can opportunistically allocate across sectors, regions and assets classes are in high demand, as are sales people who can partner with clients and investment professionals to design suitable portfolios to meet client needs. The industry hasn’t seen change of this magnitude in decades.”

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The paper, Brave New World: Assessing Volatility Strategies for Portfolio Construction, looks at the range of asset protection strategies for volatile markets that are based on the VIX volatility index and assesses their suitability for Australian investors. 

Interest is growing in investment strategies which seek to reduce the impact of market volatility on investment returns or actually exploit that volatility to make money for investors. This is being driven by heightened market volatility in the wake of the global financial crisis, the failure of traditional volatility protection strategies to protect investors and structural changes to asset markets that are increasing volatility, like high frequency trading. 

A number of new managed funds have been launched since 2008 that seek to address these needs. 

The paper warns that simply being “long volatility” is highly likely to be a loss-making strategy because of the high cost of buying and holding VIX futures. 

Using an actively managed volatility strategy with a bias to absolute returns is a better approach to mitigating losses in falling share markets and can produce higher returns overall for equities investors. 

Simple volatility strategies tend to succeed in reducing losses when the share market falls sharply, but also reduce potential returns when markets are rising. 

Active management of volatility can overcome this problem by exploiting mispricing and relative value opportunities in the VIX options market. 

“Volatility strategies that systematically exploit the alpha inherent in VIX options markets, or those that access VIX futures exposure when holding costs are not prohibitively expensive, can be combined with absolute shares funds to produce superior returns when compared with long-only equity market exposure,” the paper concludes.  

The research tested a number of different investment portfolios, which combined varying amounts of volatility strategies and actively managed absolute return and hedge fund strategies. 

It found that a portfolio which uses a specific combination of long-volatility strategies, volatility-arbitrage strategies and absolute return strategies can produce superior returns to other approaches, including a long-only equities strategy, over the long term.

6 August 2012

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The eurozone accounts for around 10% of the value of world stock markets and European companies derive less than half of their profits from within the euro-area. What is going on in Europe has no bearing on housing starts in the US (which are picking up) or electricity output in China (which is not). Greece is neither here nor there in the context of a $14 trillion European economy. But markets hate uncertainty and that is what we must accept for the next few months.

Volatility of markets is something that we are going to have to get used to. Indeed, the dramatic ups and downs that have characterised the Japanese market over the 20 years of its post-bubble deleveraging could be the template for Europe as the painful process of mending the region’s balance sheets is endured for years to come.

This is an extremely difficult environment for investors, especially if your main experience of investing was during the aberrational years between 1982 and 2000, when everything went up and the investment industry’s idea of risk was moving too far from a rising benchmark.

Now the risk is the real one that you lose money and investors are quite rightly switching on to the importance of capital preservation. If you lose a third of your money you have to grow what you have left by 50% to get back to where you started.

A year ago the market fell sharply to a new trading range at the bottom of which investors looked at valuations (especially as indicated by the hard reality of dividend yields) and thought the rewards on offer made the risks worth taking. I expect something similar will happen this time around. European shares are cheap.

They trade on around 10 times expected earnings (just nine in the UK), dividend yields are often higher than those on corporate bonds and government debt, cash flow is strong and companies have lower levels of borrowings than for 20 years or so.

The corporate sector is quite strong. Investors have to make a decision in today’s volatile markets. They can attempt to catch the increasingly frequent waves and protect their portfolios during the commensurately frequent downturns or they can accept that this type of market timing is impossible. In that case they must focus on quality – companies with pricing power, good managements, recurring revenues, a spread of clients and robust balance sheets.

They must buy these companies at a sensible price and they must hold them through the inevitable sentiment-driven ups and downs. They must, in other words, follow the likes of Warren Buffett and think like business owners.

European politics and macro-economics are a mess but the region is home to many excellent businesses with fantastic prospects in places such as the US and the Far East, where life is going on even while Europe makes a hash of it. Shares in those companies won’t bounce back immediately, but in 10 years you may well look back and think that the summer of 2012 was a pretty good time to be investing in these long-term winners.

Five ways to handle volatility – FidelityWhile many investors are choosing to take risk off the table, this might not be the best strategy, particularly for those with long-term goals.

1. Keep calm – “The worst thing investors can do is to over-react to market volatility. They will usually respond more slowly than the markets as a whole. This means they will be late to the party when markets rise and also risk bailing out after markets have already corrected, crystallising their losses.”
2. Don’t blow things out of proportion – “The eurozone accounts for only around 10% of the overall market value of global stock markets.  Europe is not the only story for investors today. “Even in Europe, many of the largest companies continue to do well, protected from problems on their doorstep by successful operations around the world and especially in the faster-growing emerging markets.”
3. Diversify – “Investors should ensure that their investments are well-spread between different asset classes, such as equities, bonds, commodities and cash. Government bonds in Germany, the UK and US have all performed well during the latest bout of equity volatility as investors have sought safe havens for their money, providing investors with an important source of performance.”
4. Consider the price you pay – “Longer-term what matters is the market’s valuation, so investors should look at the price they are being asked to pay today. The average multiple of a company’s earnings that a share price represents is actually cheaper than at any point since the late 1980s. Only at the bottom of the market in March 2009 were shares much cheaper on this basis than they are today.”
5. Stick with it – “The beauty of regular saving, say monthly, is that it forces you to invest at times like these when the market has fallen and you instinctively prefer to walk away. That makes sense from a survival point of view (which is why we are hard-wired to do it), but it does not usually make sense from an investment point of view. Volatile markets create opportunities and a mechanical investment approach obliges you to take advantage of them.”

13 July 2012

This document is issued by FIL Responsible Entity (Australia) Limited ABN 33 148 059 009, AFSL No. 409340 (“Fidelity Australia”).  Fidelity Australia is a member of the FIL Limited group of companies commonly known as Fidelity Worldwide Investment. This document is intended for use by advisers and wholesale investors. Retail investors should not rely on any information in this document without first seeking advice from their financial adviser. This document has been prepared without taking into account your objectives, financial situation or needs.  You should consider these matters before acting on the information.  You also should consider the Product Disclosure Statements (“PDS”) for respective Fidelity products before making a decision whether to acquire or hold the product.  The relevant PDS can be obtained by contacting Fidelity Australia on 1800 119 270 or by downloading from our website at www.fidelity.com.au. The issuer of Fidelity’s managed investment schemes is FIL Responsible Entity (Australia) Limited ABN 33 148 059 009. Details about Fidelity Australia’s provision of financial services to retail clients are set out in our Financial Services Guide, a copy of which can be downloaded from our website at www.fidelity.com.au. © 2012 FIL Responsible Entity (Australia) Limited. Fidelity, Fidelity Worldwide Investment and the Fidelity Worldwide Investment logo and F symbol are trademarks of FIL Limited.

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An exposure to volatility can offer investors the opportunity to enhance performance, either as an investment in its own right or as a hedging instrument, according to Russell Investments.

Russell cites an exposure to volatility as a relatively new and technical investment area, and has released a new research paper to provide education and encourage discussion on the topic. The paper details the features of volatility as an investment and the role it can play in a portfolio, with the aim of educating investors on its benefits and risks.

Volatility as an investment allows investors, in most cases, to benefit from the difference between the future volatility of an asset class and the implied volatility of options based on that asset. There are a number of strategies and products that enable investors to gain such an exposure.

The use of volatility products is currently not widespread and as such there could be a first mover advantage, but Russell has found that the main barrier so far has been education, according to Chris Inman, Senior Analyst, Russell Investments.

“We’re not recommending that all investors rush into volatility products, especially if they’re inexperienced and not prepared for the potential downside. But we believe that given the right education and knowledge of risks, volatility products will become more popular with institutional investors in particular,” Mr Inman said.

Different approaches

There are a variety of instruments that provide a ‘pure’ exposure to volatility such as VIX futures and variance swaps. Using such derivative instruments, there are two main strategies for investing in volatility; one is to go long, which in most cases provides downside protection in the event of heightened volatility which tends to coincide with negative equity returns. The second strategy is shorting, which effectively involves selling insurance to investors who are willing to pay a premium to protect themselves against the risk of volatility and poor returns.

Mr. Inman warns that a short volatility investor needs to be comfortable with the risk that should an event materialise which causes the market to be more volatile than anticipated, they will lose money. ‘”After all, there is a reason why investors pay premiums to protect against volatility and poor returns in the first place,” he adds.

Due to the nature of payoffs, an exposure to volatility is most suited to institutions (including superannuation funds) as it is important to have the funding to be able to sustain potential losses. Individual traders and retail investors should approach volatility with caution and be well prepared for the risks.

Current trading of volatility is most commonly linked to US indices such as the S&P 500. It is not yet a widely used strategy in the Australian market.

“The key to acceptance in all markets is to ensure investors know about the uses of volatility products and don’t dismiss it simply because it can initially be difficult to understand. While it’s not for everyone, there is scope for more institutions to get involved and find volatility a useful addition to their portfolios,” Mr Inman added.

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