Volatility-Focused Strategies Gain Prominence, Yet Consultants Skeptical of 'Marketing Gimmicks'

(November 7, 2011) – As markets continue their bumpy course, institutional investors are continuing to search for new strategies to protect their portfolios.

Perhaps the most recent addition to the volatility-reducing lineup: a resurgent low- and managed-volatility equity product lineup. 

“Investors are desperate for a model that is responsive in different market environments – controlling downside risk while not sacrificing upside potential,” Michael Dunn, chief research officer of Boston-based TruColor Capital Management, told aiCIO. “There’s a herd mentality in extreme downside markets, and managed-volatility strategies aim to limit exposure during such periods especially,” he said.

TruColor Capital Management has claimed to position themselves to benefit from the desire among investors to limit the volatility of asset classes in their portfolios, developing a new approach — called Tactical Volatility Rotation — that relies on the predictability and persistence of volatility, the firm said. The strategy rotates dynamically among asset classes and markets based on patterns of volatility, reducing market exposure before down markets and increasing market exposure before up markets, according to the firm. TruColor’s founding partner Mark Pearl asserted that the new investing approach works best in volatile asset classes, such as emerging markets and small-cap equities. “We wouldn’t use this strategy in most bond markets,” he said.  

The strategy, to a degree, is meant to compete with the spate of risk parity products in existence and coming to market – most based on a the same concept of diversification as traditional portfolio management while avoiding the problem of lower-risk assets diluting overall returns, by using leverage. Noting some skepticism on the strategy, however, TruColor’s report stated: “While risk-parity strategies fared relatively well during the recent crisis, they have their detractors. The claim is that risk parity doesn’t actually produce a better risk/return trade-off; it just takes the standard benefit of a diversified portfolio and borrows to boost returns…”

Consultants, however, voice caution over the host of low-volatility strategies that have come to market. “These strategies may be marketing-driven in response to the current turbulent market environment,” NEPC’s Erik Knutzen told aiCIO. “There are certain timeless approaches that make sense,” he said, referring to risk parity, which has attracted attention as of late — a strategy that NEPC has championed. “Some of these new low volatility strategies may leverage previous ideas – but take advantage of what appears to have worked in the most recent environment…We argue that you shouldn’t build a portfolio based on only one return anomaly, since those anomalies can be arbitraged away,” he continued, adding that NEPC agrees that investors should be dynamic in their allocation based on risk and return.

NEPC’s Chris Levell added that in terms of allocating capital by their risk levels, leverage may be a necessary evil. “While leverage isn’t part of the theory of risk parity, it is part of the practical application,” Chris Levell, NEPC partner, told aiCIO. “Leverage allows you to exceed the returns of risky assets as you go further out along the efficient frontier.” 

Yet, vendors defend their new investing strategies, which they deem innovative. A report by TruColor on its Tactical Volatility Rotation (TVR) stated: “As Albert Einstein is supposed to have said (but probably didn’t), the most powerful force in the universe is the compounding of returns. What he should have added is that volatility is the greatest opposing force to compound returns. More volatile investments require higher average returns to get to the same final wealth as less volatile investments. Or put another way, an investor who puts money in a volatile investment with a particular average return will end up receiving a long-run compound return below that average, ending up with less wealth than might have been expected. How much less is directly proportional to volatility.”

Referring to Tactical Asset Allocation (TAA) and TVR, the report continued: “TAA typically bases its market timing decisions on notions of value and the relative cheapness or richness of the assets. In contrast TVR uses patterns of volatility to make its timing decisions, reducing market exposure before or during down markets and increasing market exposure before or during up markets. As an example, one well-known pattern is that rising volatility is associated with negative market returns; positive returns often follow volatility peaks.”