In 2009, U.S. banking regulators subjected 19 of America's largest and most important banks (the "Too Big To Fail" ones) to so-called stress-tests in order to understand how well each bank's capital reserves would meet different challenging economic scenarios.

Here's a thought: Stress-testing portfolios isn't only a smart idea for banks - individual investors could be taking that approach too. In these volatile economic times, all kinds of hedging strategies are being put to the test. Now more than ever, asset managers and investors alike should be assessing how well portfolios are hedged for volatility. Which strategies are best able to deflect volatility in client portfolios when real market stress shows up?

Unfortunately for most investors, the past several months have provided ample opportunity for analysts to gauge risk mitigation (and the lack thereof). As seen in the first chart, "High Anxiety," volatility, as measured by the value of the Chicago Board Options Exchange Market Volatility Index, has increased sharply of late amid deep concerns about Eurozone banks and the fiscal health of governments in much of the developed world.

Anxiety really took off in August following Standard & Poor's decision to downgrade long-term U.S. government debt to AA+ from AAA. For at least the following month, the VIX remained well above the 30.0 level - at least twice the level we saw most of the year. In fact, in the month following the downgrade, the S&P 500 index had 10 days with swings of 2.5% or more in either direction; it had only three the prior year. (For those who remember the darkest days of the financial crisis of 2008, the bankruptcy of Lehman Brothers saw volatility spike from 30.3 - an already anxious level - to more than 80 at the end of October that year.)

In many respects, the drama playing out in Europe today is similar to what occurred on our shores back then: VIX levels indicate heightened anxiety that the situation is likely to get worse before it gets better. These wild mood swings provide a good laboratory to dissect the performance of risk-mitigating strategies.



As seen in the second chart, "The Perfect Volatility Hedge," those chaotic conditions impacted alternative strategies to varying degrees. To dig deeper, we've charted the performance of a hypothetical $10,000 investment in each of six common alternative or risk-aware classifications alongside the Mixed-Asset Target Allocation Growth and S&P 500 Index Funds groups.

The most obvious choice for the perfect volatility hedge is Dedicated Short Bias Funds. They've performed as advertised, rising quickly (they are frequently leveraged) as equity markets tanked. However, timing the ownership of these - particularly the leveraged versions - can be hazardous as their choppy values prove. In fact, in this example, if you did not own a short-bias fund before the S&P downgrade, virtually all of your upside performance was lost.

Both the Commodities-Precious Metals and the Precious Metals Funds groups produced plus-side performance throughout much of the market dislocation, but the Commodities classification - which is entirely ETFs that buy futures contracts - was a better overall hedge, as the mutual funds often sank when mining stocks dropped in tandem with general market conditions.



Notably, the correlation between these two groups is 0.49 (on a scale where 1.0 is perfectly correlated positively and zero is no correlation), meaning less than 25% of their variation is related. Seen from this angle, Precious Metals Funds are not a good substitute for their ETF cousins. But those ETF products weren't completely faultless as gold markets lost ground toward the end of September and Commodities-Precious Metals slipped in their ability to provide adequate cover.

We also note that Equity Market Neutral Funds and Absolute Return Funds achieved nearly the same results. During the tumult, each declined modestly by about $300 in our hypothetical $10,000 investment. Given their similar performance (and high correlation of 0.94) it's completely understandable if investors treat these two strategies as substitutes for one another.

Although Absolute Return Funds are sometimes associated with Long-Short Equity Funds, the Long-Short group bore little resemblance to Absolute Return as it slumped virtually lockstep with the S&P 500 Index Funds; the short portion provided some cushion but, broadly speaking, managers in this category have been caught flat-footed. If the justification for this strategy is the diversification benefit, it should confer a much lower correlation with a popular core holding such as Mixed-Asset Target Allocation Growth Funds than the 0.99 figure it realized.

Controlling volatility is, like insurance, something that seems too expensive until you really need it. And given the severity of the issues besetting the world's economic and political leadership, it also seems doubtful that volatility will soon pass. But treating all alternative strategies as equivalents or substitutes will not solve the downside protection investors need. As recent data suggests, some are good hedges, some are good diversifiers, and some do very little.


Jeff Tjornehoj is in charge of Americas research at Lipper.