During the second half of 2011, as well as during the 2008 global financial credit crisis, volatility rattled financial markets and rendered investors nervous. As a result, new products specifically built to address volatility in investors' portfolios have been emerging.
"The volatility we've observed in the market in the last decade has been nothing short of extreme," said Jennifer Young, CFA, President and Co-Chief Executive of INTECH Management LLC, which has $38 billion in assets under management as of Sept. 30, in both large-cap U.S. and global equities. "This creates an environment for investors where the challenge is that it is more difficult to determine how to best measure and manage risk. Clearly, a focus on risk management in an increased-volatility environment is something we are seeing more and more."
The Chicago Board Options Exchange Market Volatility Index, or VIX, which measures the implied volatility of the Standard & Poor's 500 index options and is one of the main measures of expectation of stock market volatility, has reached new highs in recent years. On Oct. 20, 2008, in the midst of that year's financial crisis, it increased to 79.13. More recently, it rose to a 29-month high of 48 on Aug. 8, according to Bloomberg data. It has mostly hovered in the mid-40s since then, reaching 43.05 on Aug. 19 and 45.45 on Oct. 3. The recent rise in volatility was prompted mainly by worsening sovereign debt problems in Europe and slowing growth in the U.S. The VIX was back down in October, trading at 24.52 on Oct. 29 as investors were slowly regaining confidence that the European crisis may finally be properly addressed and that corporate earnings in the U.S. may not be as disappointing as initially thought.
Volatility refers to the fluctuations in a security's value, or in other words, to the uncertainty related to changes in a security's value. Typically, the higher the volatility, the riskier the security, and high volatility usually stirs strong uncertainty among investors. Volatility can be measured in several different ways. Beta measures the volatility of a security relative to the overall market. The standard deviation measures how much a security's value moves from an average of a specific period.
Volatility is often seen as detrimental to portfolios because wide swings can be scary to investors. If they need to sell a security during volatile times, there may be a higher probability of loss. But volatility can also be a boon to some investors because it can offer opportunities to buy securities on the cheap and sell high, turning a quick profit. "INTECH views volatility as a source of reward as opposed to thinking about it only as a source of risk," said Young. But most often, investors want to protect their portfolios from the negative effects of volatility and to bring stability to their portfolios.
Overall, considering the volatility of the past few years, investors have shifted their attention from relative risk to absolute risk. "An absolute risk strategy would seek more to avoid dramatic downswings," said Adrian Banner, Ph.D., Co-Chief Investment Officer at INTECH. "You don't gain as much on the upside, but you have greater downside protection. There's still a focus on risk, but it's shifted from relative risk to absolute risk."
There are several ways to mitigate volatility's effects on a portfolio. The main way is to diversify asset types in a portfolio. In times of high volatility, many experts recommend reducing an equity exposure and increasing exposure to fixed income assets. But considering low yields currently available in the fixed income market, it may not be the best long-term strategy.
With the increased volatility of recent years, market participants have come out with new products too.
INTECH announced on Oct. 5 the launch of a suite of absolute volatility equity strategies, offering institutional investors the potential for both equity-like and abovemarket returns at lower volatility than is associated with capitalization-weighted equity indexes.
"These new products extend our expertise in volatility to constructing portfolios with lower standard deviation, or absolute risk, than the market," said Young.
Its Low Volatility strategy seeks to generate modest returns in excess of its respective cap-weighted benchmarks, over time, at significantly lower levels of absolute volatility and higher Sharpe Ratios, which are used to measure risk-adjusted performance. The firm's Managed Volatility strategy seeks to generate returns in excess of its respective cap-weighted benchmarks, over time, at lower levels of absolute volatility and substantially higher Sharpe Ratios. These new strategies attempt to minimize a portfolio's standard deviation rather than its tracking error.
"Our Low Volatility strategy attempts to provide long-term, market-like returns net of fees, with much lower standard deviation than the benchmark index," said Young. "There's a focus on beta in the marketplace. However, investors would ideally like market exposure at less risk than what cap-weighted indexes provide." She explains that the Managed Volatility strategy goes one step further because there's also a strong desire for returns above the market. "This product attempts to provide 3% to 4% returns, in excess of the benchmark index, with lower standard deviation over time," she added. "Both products concentrate on absolute standard deviation, generating high Sharpe Ratios and dampening volatility."
These new strategies can be managed against both U.S. and non-U.S. benchmarks. INTECH said it has already found a healthy amount of interest domestically as well as overseas. "The idea of this type of strategy isn't necessarily new, however it's coming back into favor given the negative experience investors have had on the downside in the recent past," said Young.