Managing volatility for performance and safety
The last decade has left investors painfully aware of the importance of volatility. Two major bear markets in 10 years have left many scarred by the experience. Clearly, an investment approach that captures the growth of equities together with a braking system that tries to prevent accidents would be ideal for navigating such difficult markets. We believe that investors can come close to realising this ideal by carefully measuring and managing the volatility in their portfolios.
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Any mechanism that can smooth volatility in an equity portfolio is not only useful in its own right but, by improving the investor’s day-to-day journey, it may also help them to avoid major crashes. Volatility often accompanies market collapses. Figure 1 (light blue line) shows the volatility of the US Standard & Poor’s 500 Index between 1928 and 2012. It can readily be seen that many of the big corrections of this 84-year period, such as 1929, 1937, 1974, 1987, 2001 and 2008, have been associated with high volatility.A basic mechanism for capping volatility is pretty straightforward to establish for a portfolio of risky assets such as equities. First decide on a maximum level of volatility, say 15% a year. Then monitor the portfolio volatility and whenever it exceeds this fixed 15% cap, sell enough risky assets to ensure that it falls back to 15%. Thus, for example, if portfolio volatility rises to 20%, bring itback down to 15% by selling a quarter of the stocks for cash.
Figure 1: Volatility often presages problems
Source: Bloomberg and Schroders. As of December 2013. Indices used are the S&P 500 [Div Adjusted] (1928–1988), S&P 500 Total Return (1988–2012). Volatility on any day is measured as the annualised standard deviation of daily returns in the previous 30 days using closing prices and de-risking, if required, is assumed to occur at the close on the same day.
A simple portfolio braking system
A basic mechanism for capping volatility is pretty straightforward to establish for a portfolio of risky assets such as equities. First decide on a maximum level of volatility, say 15% a year. Then monitor the portfolio volatility and whenever it exceeds this fixed 15% cap, sell enough risky assets to ensure that it falls back to 15%. Thus, for example, if portfolio volatility rises to 20%, bring it back down to 15% by selling a quarter of the stocks for cash.
Once the portfolio volatility moves back towards the 15% level, the cash can be gradually einvested in risky assets. By following this simple, ystematic rule, volatility should be ffectively limited to a maximum of 5% a year (see Figure 1, dark blue line).
Over the very long term, the operation of such a volatility cap seems to e no material mpediment to returns. A 15% per annum volatility cap applied continuously to the US stockmarket over the last 90 years would have performed similarly to the uncapped equity market over the entire period. Moreover, it would have reduced losses in 12 of the 13 ‘crash years’ (calendar years where the market fell by more than 10%) that occurred during that time, and the benefit achieved would have been significant in seven of those cases (see Figure 2).
Figure 2: Analysis of major corrections in the US equity market since 1928
Source: Bloomberg and Schroders. As of 31 December 2013. Indices used are the S&P 500 [Div Adjusted] (1928–1988), S&P 500 Total Return (1988–2013).
As we noted earlier, short-term volatility can alert us quickly to the fact that a market correction is underway. The volatility cap responds automatically to this warning, de-risking the portfolio so that it is better positioned to withstand the blow. Then, after the market finally finds the bottom and volatility subsides, the portfolio can gradually re-risk and participate in the recovery.
Alas, no braking system is perfect
Unfortunately, all risk management techniques have unwanted side-effects, and the basic volatility cap is no different. Consider the market scenarios illustrated in Figure 3. (Ignore the dark blue lines for now, we will return to those in the next section.)
Figure 3: How well does the cap fit in different conditions?
Source: Bloomberg and Schroders. As of 31 December 2013. S&P 500 Index. Above results are a back-test. Performance is net of transaction costs and gross of fees. Owing to the unpredictability of the behaviour of markets, there can be no guarantee that the volatility management strategy will meet its objectives.
Big market corrections such as the one we experienced in 2008 (Figure 3a) are typically violent. Our volatility cap was quickly activated and proved its worth by halving a potential loss of 40%. Furthermore, sustained bull markets are usually well behaved in volatility terms. Between 2003 and 2007 for example (Figure 3b), the 15% volatility cap was rarely triggered, so the capped portfolio remained almost fully invested throughout and hence delivered a very similar return to the market.1
But rising markets are not always stable. Bear market rallies like 2009 (Figure 3c) can exhibit high volatility, leading to underperformance as the volatility cap forces de-risking despite the rising market – analogous to ‘riding the brake’ while keeping a foot on the car’s accelerator. Although this is not an ideal short-term outcome, it should not give rise to serious concern: over the whole two years from 2008 to 2009, the volatility-managed strategy outperformed the market, saving significantly more in the crash than it gave back on the rebound.
Furthermore, bear markets are not always volatile. On occasion a significant market loss can build up steadily over a lengthy period, as when the Internet bubble deflated between June 2000 and December 2002 (Figure 3d). In such a scenario the basic volatility cap remains inactive and does nothing to mitigate a substantial loss.
While history would suggest that this last scenario is a rare occurrence, the magnitude of the potential loss is still unacceptable to many investors who have limited risk tolerance. Could we adapt the basic volatility cap mechanism so that it will always limit losses to a specified maximum level, even when the loss develops gradually, as in the early noughties?
1 You may be thinking as you read this paragraph: ‘If volatility is typically subdued during rising markets, why don’t I boost my return by increasing market exposure when portfolio volatility is lower than 15%, as well as decreasing exposure when the volatility goes above 15%?’ In other words, 15% becomes a ‘volatility target’ rather than merely a ‘volatility cap’. There is a certain appeal in the symmetry of the volatility target mechanism, but we would urge caution for a couple of reasons. Firstly, it requires continuous adjustment of the hedging position to bring it back to the target level, which will gradually rack up substantial transaction costs. Secondly, it requires the portfolio to be leveraged when its volatility falls below the target. Although this should not give rise to serious concern (since you only gear up when risk levels are low), many investment guidelines prohibit any form of leverage. For those few who are not subject to this constraint, a ‘volatility collar’ may be worth considering. Here the volatility is not just capped at 15%, but also ‘floored’ at 9%, let’s say. When volatility exceeds 15% we de-risk back to that level; when it falls below the 9% floor we re-risk back up 9%; and when volatility lies between 9% and 15% no action is taken with the portfolio, thus saving on transaction costs. Historical analysis would suggest that a volatility collar may achieve better risk-adjusted returns over time than a simple volatility cap.
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