To some clients, “volatility” is a dirty word because it conjures up ideas of uncertainty and risk.
However, true value investors know that volatility doesn’t always deserve its negative reputation.
Disciplined value investors exchange volatility, some liquidity and the prospect of periodically underperforming indexes for excess returns and lower risk over time. Volatility isn’t the same as risk but is the bouncing around of stock prices; risk means the chance of permanently losing capital.
For clients with a multi-year horizon trying to allocate capital, a good start is to examine investment managers with a history of success yet a bout of weak performance. Regression to the mean is a powerful force in financial markets, and above-average long-term records almost always include periods of sub-par returns.
Understanding this, capital allocators can become much better investors.
In addition, investors should beware the siren song of investments and managers promising high returns with low volatility. Eliminating volatility, including temporary mark-to-market declines in security values, is likely to eliminate returns, as many high-fee hedge funds have discovered in recent years.
When equity and bond indexes become expensive by historically significant valuation metrics, active value investors are likely poised to outperform. It is worth noting that underperformance by concentrated value investors is a feature, not a flaw, of their approach.
Such periods are typically followed by far more agreeable results. History tells us that even the best active value investors experience underperformance relative to indexes nearly one-third of the time.
Among fiduciaries, current trends favor passive strategies with limited liquidity or low-volatility returns modestly above risk-free rates. A skeptic may ask, why abandon such strategies for an active value approach that promises periodic underperformance?
Generally, there are three reasons to adopt a value investing approach.
First, value investors are more sensitive to absolute valuations, something about which investors should be concerned, given the high median valuation levels.
Second, value investors seek out investments using metrics with a business rationale for a return. Active value managers are drawn to securities that, for one reason or another, already have reduced expectations and a low valuation.
Finally, value investors are willing to trade off liquidity and temporary declines in market value for higher long-term returns.
Unlike index funds, or any number of strategies that are similar, value managers must conduct detailed fundamental research, hold cash in the absence of bargains, have the courage of their convictions, and be willing to tolerate occasional eye-watering and stomach-churning volatility that comes with owning a short list of securities.
This story is part of a 30-day series on ways to build a better portfolio.