Volatility nearing the end of a three-year holiday

NEW YORK — Active managers that thrive on volatile markets soon may get their day in the sun. Recent data from Wilshire Associates Inc. in Santa Monica, Calif., show just how long those managers have waited.
A Wilshire report, “Manager Behavior in a Low Volatility Market,” shows that market volatility in the past three years is well below the 30-year average. From the beginning of 2004 to the end of 2006, volatility in the U.S. market never rose above 10%.
The 30-year average stands at 14.3%, and the average volatility for the three years prior to 2004 was 18.8%.
After such an extended calm, consultants expect more volatility soon.
“We’ve told clients we’ve been in a lower-volatility environment over the last three years,” said David Ritter, senior vice president and principal at LCG Associates Inc., an Atlanta-based consulting firm. “If you believe in historical patterns, you would expect the market to become more volatile.”
Consultants already are asking managers how they are prepared for the change in volatility, Mr. Ritter said. “How are you positioning the portfolio to take advantage of volatility or reduce the downside of it?”
The Wilshire report does not attempt to predict when volatility will increase; it simply shows how long volatility has stayed low in the U.S. market.
Steady and predictable moves from the Federal Reserve, along with consecutive periods of growth in corporate earnings, have caused the drop in volatility, the report states.
That decrease has caused a severe drop in tracking error for most managers. Of the 131 large-cap-growth managers in the study, 77 had experienced a drop in tracking error of 50% or more over the previous three years.
The drop in tracking error was not limited to large-cap-growth managers. Of the 153 small-cap-growth managers studied, 97 had a drop in tracking error of 50% or more. Also, 112 of the 235 large-cap-value managers had a similar drop.
Small-cap-value managers were less affected. Only seven of the 72 small-cap-value managers saw their tracking error fall by 50% or more.
Alpha available
Low market volatility has not left managers completely void of alpha opportunities. “During this low-volatility market environment, active managers have been able to take enough active risk in aggregate that investors should reasonably expect not to lose money after fees are deducted,” the Wilshire study states.
However, “a lot of managers would welcome a higher-volatility market,” said the author of the report, Michael Rush, a vice president in the Pittsburgh office of Wilshire Consulting, the pension advisory business unit of Wilshire Associates.
Those managers could get their wish if history repeats itself. Over the past 30 years, there was only one time period with a longer stretch of low volatility — from 1993 to 1996.
“At some point, volatility will increase, and tracking error will go up, so expect quarterly numbers to change more than they have over the past three years,” Mr. Rush said.
Mr. Ritter said when his firm’s consultants talk with managers, they want to hear whether the particular manager plans to take advantage of the volatility or whether the manager expects performance to suffer from a more volatile market.
Managers will have different expectations, based on their investment style, but “we want an indication of how that manager thinks they will be performing,” he said.
Consultants are also talking to their clients about the expected return of volatility.
“Everyone has been pleasantly surprised at how long this low-volatility market has gone on,” said Chris Meyer, a managing principal and chief investment officer for Fund Evaluation Group LLC in Cincinnati. “Something’s going to happen here. That’s why [investors] need to position their portfolio so that when something does happen, they can benefit from it.”
Mr. Meyer recommended that clients consider investing in hedge fund strategies that perform well in a volatile market, and also distressed-debt managers, which do well when credit spreads widen, and defaults increase.
Managers that have a tilt toward high-quality, mega-cap stocks also should get a closer look, he said.
“When investors get nervous, they go to the names they know. You want to stay ahead of the curve,” Mr. Meyer said.