Last year was a terrific one for e equity fund managers as most of the global equity markets posted superb returns. In the U.S., the S&P 500 returned a record breaking 32.39% and the average large cap core manager, based on the Lipper category average, posted 31.63%. Overseas, the international developed markets returned 21.44%, by no means a small feat. Given the impressive gains, volatility and downside protection, on every manager's mind following the 2008 financial crisis, may have taken a back seat to seeking high returns.
Risk Management Implementation
History has painfully taught us that roaring, secular bull markets are often followed by significant downturns, rising asset class correlations and heightened volatility. The truth is very few managers can predict when the storm is coming and by the time the realization kicks in, it is often too late. Hence, when it comes to portfolio and risk management, it is important for managers to be proactive and to be prepared for all types of volatility regimes. In that context, this seems an appropriate time for managers to reconsider and evaluate risk mitigating mechanisms that meet their risk tolerance levels and budget.
Following the 2008 financial crisis, managed volatility equity strategies have gained popularity and greater acceptance among investors. The common feature among the various types of risk management strategies is that they provide a degree of upside participation in the market while limiting the downside exposure. The process by which each strategy achieves its objective differs as does the risk/return profile of each strategy.
Risk controlled or target volatility strategies set an explicit risk level for the portfolio. Most risk controlled strategies employ dynamic allocation between a risky asset, or a portfolio of risky assets, and a risk-free asset. The amount of allocation to each asset depends on the market environment and the estimates of short-term and longer-term realized volatility. During periods of relatively low volatility, allocation to the risky asset increases, sometimes over 100% if leverage is used. Conversely, when volatility rises, the strategy lessens the allocation to the risky assets and increases allocation to the risk-free asset. Rebalancing can occur on a higher frequency basis such as daily or on a lower frequency basis such as monthly to exploit changes in volatility. Hocquard, Ng, Papageorgiou (2013) found that volatility timing through a constant volatility framework not only controls risk but also reduces it and improves returns. Managers can use the available risk budget effectively and ensure that drawdowns are consistent with the volatility targets.
The past five years also saw the proliferation of low volatility or minimum volatility strategies that seek to lower total portfolio volatility. Often termed as smart beta or alternative beta, these strategies achieve their goals either by constructing a portfolio of stocks that exhibit low volatility or low beta, or based on mean-variance optimization which takes into consideration of the correlation between stocks. Clark, de Silva and Thorley (2006) constructed minimum-variance portfolios that result in annualized realized volatility at three-fourths that of the broad market. Based on volatility sorted decile portfolios, Blitz and Vliet (2007) showed that selecting the top decile portfolio (the least volatile bucket) based on trailing volatility resulted in realized volatility about two-thirds of the market volatility. Regardless of the portfolio construction, both strategies deliver lower total portfolio volatility than a market-cap weighted benchmark and are more risk efficient. Over the past 23 years, both the MSCI USA Minimum Volatility Index and the S&P 500 Low Volatility Index returned 10.93% and 10.24% (vs. S&P 500 10.03%) respectively on an annualized basis with volatility of 11.49% and 11.17% (vs. S&P 500 14.7%).
Lastly, using a derivatives overlay presents another venue for risk management. The potential benefits of using the CBOE Volatility Index, or VIX, as a hedge for equity portfolios have long been established in academic literature. Since the spot VIX is not investable, managers with long exposure to an equity portfolio can use VIX futures and the VIX Futures Index linked products to potentially hedge tail risk events. One example of using implied equity volatility to manage risk is the S&P 500 Dynamic VEQTOR Index. The index dynamically allocates between the S&P 500, the S&P 500 VIX Short-Term VIX Futures Index and cash based on the realized volatility of the equity market and the implied volatility of S&P 500 options. Based on live performance data, the index returned 17.41% in 2011, a period marked by see-sawing volatility in the U.S. equity markets, with 10.78% annualized volatility. During the same period, the S&P 500 returned 2.11% with 23.37% volatility. It is worth noting that while the hedging properties of the VIX futures are well established, their potentially high carrying costs should be carefully evaluated by every manager considering this option.
Don't Wait Till the Storm Comes
The past year has been marked by low volatility and significant opportunities for capital appreciation. Financial history has shown us that while volatility levels can remain constant for a long time, spikes can occur very suddenly and sharp downturns develop rapidly as fears take hold. The strategies highlighted above are just examples of risk mitigation mechanisms managers can employ to protect large portfolio drawdowns. Depending on the prevailing volatility levels, a manager's risk budget, and the managers' assessment on the probability of an imminent tail event, any one or a combination of these strategies can be incorporated as part of risk management.
Aye M. Soe is director of index research and design at S&P Dow Jones Indices.