October 08, 2019
Risk as a starting point — not an afterthought
October 08, 2019
Dazzling investment returns make good headlines─as do spectacular investment crashes. But seldom do we read stories about funds that excel in controlling volatility while delivering strong, competitive returns. Yet managing volatility is the key to surviving a sharp market downturn.
Most investment managers designate a benchmark to evaluate returns. Far fewer designate a benchmark focused on volatility. We are one of the few who do. Our investment process begins with risk. Depending on client preferences, we specify a target range of volatility, e.g., 4-10%, within which we aim to maintain the fund’s volatility1.
A link between volatility targeting and higher Sharpe ratios
Studies show that volatility is negatively correlated to equity returns. As such, it makes sense to allocate to lower-risk assets when volatility is high or rising and to riskier assets when volatility is low or falling2. In fact, data supports that managers who do so often deliver a superior Sharpe ratio3, which measures the amount of return generated given the amount of risk taken.4
The advantage of multiple asset classes
Our multi-asset portfolios hold a mix of equities, fixed income, commodity-linked notes and cash. This flexibility to diversify across asset classes is critical in controlling risk.
In fact, research shows that global equities start to move in lockstep in distressed markets.5 Equity-only managers therefore have no recourse other than to reallocate between their equity holdings and cash, viewed by some as merely “rearranging the deck chairs on the Titanic.” A multi-asset manager, in contrast, has multiple asset classes that can be rearranged to manage risk.
A forward-looking exercise
Anticipating volatility is a hallmark of our investment approach. We continually survey macroeconomic and geopolitical conditions across the globe to identify potential sources of risk that could arise. Our goal is to adjust portfolio exposures before volatility strikes.
We use the portfolio’s equity allocation as the primary lever for adjusting its exposure to risk. When we expect some event – such as an election, political instability or change in monetary policy -- to cause a spike in market volatility, we typically reduce exposure to equities. Conversely, when market conditions normalize, we restore the equity allocation to a normal range, generally 50-70%6. Display 1 shows how we have adjusted equity exposure in anticipation of various global events over the past two years.
Case in point
In the second half of 2018, there was an escalation in trade tensions that we anticipated could curtail global growth. By September we had also identified that divergence in equity market performance between the US vs the Rest of the World was approaching excessive levels. The US’s outperformance was driven by a number of factors, including the perception that the US is a safe haven and insulated from trade tensions. Expecting a market correction, we decreased our equity allocation to reduce overall risk in our portfolios, positioning towards more defensive assets. This allowed us to protect our portfolios during the Q4 2018 market correction.
Final thought: The psychological benefit of managing volatility
For investors, there is an emotional aspect of owning a fund that aims to keep volatility within a specified range. Delivering a more consistent, less volatile return stream can be of comfort to loss-averse investors, who might otherwise make rash decisions and sell prematurely.
Funds that aim to keep volatility within a pre-set range could be of particular interest to high net worth investors. Given their aversion to volatility, they might be willing to sacrifice some upside in order to minimise sharp drawdowns.