Suppressing volatility? Easy. Eliminating risk? Not so easy

For advisers and investors concerned that all this market intervention will end badly, there are ways to hedge that risk.
MAY 20, 2015
Investors recognize that we are in a unique period in the markets as a result of the unprecedented global efforts of various central banks to stimulate growth and reignite a modest level of inflation. A near-zero interest rate environment has prevailed for the better part of six years, even as the Federal Reserve's balance sheet quadrupled to $4.5 trillion by the end of 2014. Central bankers have indeed managed to suppress market volatility, to the benefit of equity investors. Contrary to what some believe, however, they have not succeeded in eliminating risk. Risk remains embedded in the markets, but it has been transformed: The likelihood of moderate losses may now be more modest, but less probable “tail risk” losses will be disproportionately more damaging. The benefits of herding market risk into a pattern of mostly small price adjustments come at the cost of the current bull market being more likely to end in another major event that — in the context of today's low volatility — seems highly improbable. Given its unpredictable nature, it's easy to shrug off tail risk, especially during a period of relative market calm. But for advisers and investors who are concerned that all this market intervention will end badly, there are ways to hedge that risk. MANAGED FUTURES For example, consider a position in a managed-futures fund. Managed futures broadly have underperformed traditional assets and alternatives as global markets moved up, a circumstance which has led to the strategy's falling out of favor with many advisers. That should not be surprising. These funds thrive on directional volatility which, as noted, policy actions generally have suppressed. The best managers should be able to generate positive returns in this environment, but are likely to lag the S&P 500. However, to view managed futures against the benchmark of the S&P 500 is to misapprehend the role these funds are designed to play in a portfolio. Further, to define risk simply as volatility is similarly a mistake. For most advisers and their clients, risk means the permanent loss of capital. That possibility is always present. The generally acknowledged solution to managing risk has long been asset class diversification. But as we saw in the financial crisis, diversification alone may not be sufficient to protect a portfolio from events in which almost every asset class declines; you have to be diversified in the right way. Managed-futures funds generally have little or no correlation with the broad equity market, a relationship that persisted even during the financial crisis. The funds offer investors what the industry likes to call “crisis alpha” — essentially downside protection during periods of market turbulence. An allocation to the asset class is an anchor to windward, and an implicit acknowledgement that markets sometimes go down as well as up. CRITICIZED FOR HIGH FEES Managed-futures funds have come in for their share of criticism over the years, primarily for what was perceived as high fees and a lack of transparency. The good news for advisers considering managed futures is that there are now many more funds from which to choose in the '40 Act space. Morningstar Inc. counts about 50 in the category. Increased competition has put pressure on managers to deliver value and to provide greater transparency to advisers and investors. Though the S&P 500 has tripled off its post-crisis lows, for many investors there remains a nagging feeling that there is something artificial about this rally, and that the good times may not last. No one knows for sure, and it's possible that the Fed will successfully navigate the unwinding of its now massive balance sheet. But for those who instinctively believe that it's not possible to legislate risk out of the markets, managed futures funds are worth a look. Matt Dority is a partner at QES, which co-created the Aspen Managed Futures Beta Index.

Latest News

More Americans are invested in the elections than the stock market
More Americans are invested in the elections than the stock market

A substantial number of people in a new 2,200-person survey believe their wealth, their "wallet power" and their retirement timelines are at stake.

Stocks rally to fresh highs as JPMorgan drives bank gains
Stocks rally to fresh highs as JPMorgan drives bank gains

The S&P 500 headed toward its 45th record in the year helped in part by a surprise interest income gain at the Wall Street giant.

Boosting payouts on cash crimps wealth management at Wells Fargo
Boosting payouts on cash crimps wealth management at Wells Fargo

Meanwhile, Wells Fargo’s WIM group reported close to $2.3 trillion at the end of last month.

Another AI-washing case shows where SEC is headed
Another AI-washing case shows where SEC is headed

The Securities and Exchange Commission has focused on "black-and-white" allegations of AI washing, but that could broaden out to a gray area that may loop in more financial services companies, a lawyer says.

High-net-worth giving splits along generational and gender lines, find BofA survey
High-net-worth giving splits along generational and gender lines, find BofA survey

More than nine in 10 HNWIs prioritize charitable giving, but demographics help shape the whys and the hows.

SPONSORED Destiny Wealth Partners: RIA Team of the Year shares keys to success

Discover the award-winning strategies behind Destiny Wealth Partners' client-centric approach.

SPONSORED Explore four opportunities to elevate advisor-client relationships

Morningstar’s Joe Agostinelli highlights strategies for advisors to deepen client engagement and drive success