When clients walk into a financial adviser's office, they usually bring along dreams of major upside. They want the next Microsoft, Google or Tesla — the big ideas everyone wants to hear about at cocktail parties. We discourage them at our peril, but it is just as important to guide clients to investments that will help manage their risk. Creating a balanced portfolio isn't sexy, but it is smart.
To this end, a new generation of products is gaining popularity. We characterize them as multi-asset, outcome-based or solutions-based.
These products can appear inscrutable — and yes, repeating words like “solutions” does nothing to explain what they are — but they have much to offer. They can be difficult to judge by classic standards, including cap-weighted Morningstar boxes, because their goals are broader than merely producing returns against a benchmark, including mitigating risk against downside in widely gyrating markets.
One outcome-based example is “managed volatility,” which can encompass a range of asset classes and employ a variety of tools including equities, fixed income, derivatives and other hedging securities, and at times even money market funds. In their most common form, these funds invest in lower-beta stocks — that have been paying regular dividends — to potentially offer equity-like returns, generate income, and lower a portfolio's sensitivity to market swings. Thus they can provide security, income and returns.
Portfolio Building Blocks
Over the last few years, many investors have added low-volatility equity strategies as building blocks to a diversified portfolio. That's the best way to think of them: building blocks. Their main implications are lower exposure to equity risk; less susceptibility to large intra-month drawdowns; and the freedom they can give investors to take on more risk elsewhere in their portfolio.
They are less core allocations than complimentary ones. Managed volatility will never be the first strategy clients invest in, but they can be as important to achieving their long-term goals as anything else in the portfolio.
Reduce Correlation, Increase Diversification
Today's markets are often driven by macroeconomic concerns rather than stock fundamentals. This has led to increased correlations between asset classes, which reduces diversification benefits. Low-volatility stocks have been less correlated with other equity asset classes. Thus they can help increase diversification to traditional cap-weighted equity returns. This is important during significant market drawdowns, when correlations among traditional equity asset classes have risen.
Strategies that focus on dividend-paying stocks also can provide advantages over similar products by offering strong yield components. They can offer attractive complements or alternatives to today's low-yielding bonds by generating income while still offering upside equity-market participation.
While especially relevant in high-volatility, low-return environments, managed volatility strategies are hardly new. Across a variety of market conditions, academic studies have demonstrated that lower-volatility stocks have the potential to outperform higher-volatility stocks. These strategies offer flexibility for investors seeking to achieve specific objectives within their portfolios, regardless of the investment environment.
Approaches and Drawbacks
Beyond low-beta, dividend paying stocks, there are many approaches to managed volatility: option-based tail risk strategies; dynamic allocation strategies, such as constant proportion portfolio insurance (CPPI); or simply adding alternatives with low correlation to the existing portfolio. Variations are wide, manager-to-manager and fund-to-fund. Investors and advisers should take care in making their selections.
Since many quality lower-volatility stocks pay regular dividends, these strategies can offer income. That can be important to offsetting their drawbacks. There is a perception that most “defensively” managed volatility products offer income and reduced volatility at the expense of upside potential. Investors may expect nominal returns to lag benchmarks in long bull market runs, since they are effectively trading some upside for risk management. Risk reduction can have costs.
However, it is important to recognize that while managed volatility strategies may not go up as much during sustained bull runs, they may not go down as much during market corrections. By design, their spikes can be lower and troughs shallower. That means they can have less room to make up when markets go soft.
Outperformance in Recent Market Downturn
The benefits of these strategies can quickly become apparent on days and weeks when markets make a dramatic turn south. The recent volatility the markets experienced during October provided us an opportunity to examine how these strategies can perform during downturns.
While past performance is no guarantee of future results, an analysis of the performance of managed volatility strategies from Oct. 8-16 demonstrated that:
• They largely did what they were supposed to do, managing downside risk across the category. While the S&P 500 declined 3.68%, 88% of the publicly available U.S. managed volatility funds beat the benchmark; the median excess total return was 1.40%.
• Despite the dramatic negative market move, the S&P 500 finished the month up 2.44%. Likewise, the median managed volatility fund finished the month in positive territory, with the excess performance during the Oct. 8-16 period driving modest monthly outperformance versus the S&P 500. Investors in managed volatility funds enjoyed upside market performance, while avoiding a good portion of the dramatic market decline.
The value in managed volatility comes from potentially getting equity-like exposure with similar returns, lower volatility and better downside performance. Some funds offer regular dividend income. We expect that in long bull markets, nominal returns would lag the broader market, but that does not fully capture the other benefits these strategies offer.
In the end, it's all about risk: adding managed volatility strategies to a client's portfolio can result in better overall risk/reward characteristics than traditional equity and fixed income mandates afford alone. Along with providing ample liquidity and investment flexibility, they can be excellent solutions for investors seeking consistent risk/reward profiles over the long term.
Thomas Hoops is executive vice president and head of business development at Legg Mason Global Asset Management.