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Managing Volatility

Meet the Round Table Participants

Paul Ehrlichman
Managing Director,
Portfolio Manager
Head of Global Value
ClearBridge Investments

Thomas Lee, CFA
Managing Director
Investment Strategy and Research
Parametric

Jeffrey H. Snyder
Vice President, Senior Consultant
Public Markets Practice Leader
Cammack Retirement Group

Round Table

The sharp drop in stock prices at the beginning of the year, followed by a quick rebound, led many investors — both institutional and retail — to conclude volatility had once again reared its ugly head. But those who keep a close eye on equity markets knew the choppiness simply marked a return to normal.

Nonetheless, given the economic and political uncertainties buffeting Wall Street, investors need to get used to higher levels of volatility. In this round table discussion, Paul Ehrlichman, managing director, head of global value and portfolio manager at ClearBridge Investments, Tom Lee, managing director of investment strategy and research at Parametric, and Jeffrey H. Snyder, vice president and senior consultant at Cammack Retirement Group, discuss how investors — and their portfolios — can weather the storm.

P&I: What's causing the volatility in capital markets today? Could investor perceptions be contributing to it? Should investors get used to it?

Tom Lee: Volatility today is not materially above the long-term average. If we use the [CBOE Volatility Index] as an index, volatility since the end of 2015 averaged a little over 21 . Long-term VIX averages in the high 19s.

The reality is people think we are in a higher-volatility environment because we came from, historically, a relatively low-volatility environment. Volatility tends to cluster into regimes. The volatility environment we're in is more normal.

What caused this to elevate? There are a lot of contributors to volatility. There are the experimental and divergent monetary policies that are being pursued across the globe, including negative interest rates. And there's also an intuitive understanding that the longer we are in this experimental monetary policy phase, the higher the risk is of some unintended consequence. We're going to have this uncertainty for a while.

Paul Ehrlichman: We call it the old normal. It does feel like the old normal of volatility and that's just something we're not used to.

In our view volatility is the way markets renorm or stabilize. We're in a period of transition, and the fear and uncertainty around that transition is creating a lot of volatility.

Partially, as Tom mentioned, it's because of the experimental policies of central bankers that are creating a lot of apprehension and uncertainty. Every word that [U.S. Federal Reserve Chairwoman] Janet Yellen uses creates massive reaction in the markets.

The current perceptions that are contributing to volatility right now are about a narrative, a story called secular stagnation. It's probably going to prove as useful as the narrative around the Internet in 2000.

What you're seeing in politics around the world is also creating volatility in the sense of helplessness and hopelessness with people — that Wall Street-Main Street gap. But in terms of the U.S. presidential election, the likely outcome will be continued gridlock, so I don't think that will be much of a contributor to uncertainty.

We view things in a more positive light. We think that we're transitioning from unsustainable drivers of growth, which is basically trading inflated assets with each other, which is fun until it isn't, and are reconnecting with sustainable drivers.

P&I: Is China part of the volatility story?

Mr. Ehrlichman: China's pretty much ground zero for a lot of the volatility we're seeing. The sentiment's mostly bearish — the slowdown in China or the debt situation in China — that's the popular narrative.

We think, instead, Chinese economic growth slowing is merely typical of a country at this stage in development. This is what happened in Singapore, South Korea, Taiwan and Japan. It just gets to be such a large economy, the growth slows down because of the base effect, but it isn't over.

As the 400 million millennials in China move up in incomes, spending is going to shift and the economy will slow. [But] the quality of the growth, which is what we're focused on, will increase, with rising value added.

For example, cars made in China used to be about 90% foreign content, now they're 90% local content. If you just look at the growth in car sales, you say, 'Oh, my goodness, it's over for China.' But you have to also look at the value-added and understand how that's going to power the consumer sector. Incomes can continue to rise even though things slow.

I don't anticipate a black swan event coming out of China. It may be a boiled frog for some sectors there — gradually rising risk levels that are ignored until they reach critical mass — but overall I think volatility stemming from China will decrease.

P&I: Should periods of increased volatility lead asset owners to change their asset allocations?

Mr. Lee: We don't think that volatility should drive changes in asset allocation. Volatility tends to cluster in regimes and it would be very hard for an investor to time an upward or downward move. We think investors should structure their portfolios for the long term.

I would say that now is a very prudent time for investors to closely observe their portfolio and make sure they have transparency into all the risks they're taking and address unintended risks.

As an example, recently investors have become very interested in hedging their currency exposure — after the strong rally in the dollar. They're hedging only after they've experienced the risk. We are advocates of investors trying to get ahead of the curve with respect to risk.

Mr. Ehrlichman: My perspective is different from Tom's. I think increased volatility is a sign of change. It is a sign for an investor to look for what asset allocation shifts they need to make.

The timing of this is difficult, but as volatility and variability pick up, it's the time to prepare to make substantial allocation shifts. As a contrarian investor, we're post-volatility investors, meaning we invest after a lot of the volatility and risk has been squeezed out and then mispriced.

We may be in an environment where, because of financial repression and some central bank policies, it's an important time to consider which assets to favor for the long term. Beware of crowded consensus areas. In the context of volatility, this would be investments possessing “low-vol” factors.

P&I: Jeff, as a consultant, when you're out talking with clients about volatility, are you recommending they keep their focus on the long term, as Tom says, or are you telling them to prepare to make some moves, as Paul suggests?

Jeff Snyder: Our business is primarily focused on defined contribution retirement plans and as you would imagine, we've been talking about this issue of volatility and the market at all of our committee meetings.

The added complexity with a defined contribution plan, as everyone on this roundtable is aware of, is the individual participant is the one who has to make these selections and the decisions.

So we do a lot of education for the plan sponsor. We do advocate more of a long-term strategy and not to overreact because you really can't time the market no matter how sophisticated you are.

We are basically urging clients to stay the course but the added layer is educating plan participants. This involves more communication to individual investors, making sure they take a long-term view.

As a consultant working with a plan sponsor or a board of trustees, it's important to really understanding the mandate and the investment manager. That's where we would work hand-in-hand with both Paul's and Tom's organizations to do due diligence and get under the hood and be able to translate that information on behalf of our clients.

Additionally target-date funds are an area that we focus on. A lot of plan sponsors are using these in their plans, and many of them, especially at the larger end, use custom portfolios. They involve some of the managers with whom we're speaking today.

Again, it's taking a long-term approach, figuring out your plan's goals and objectives as well as the mandate for your target-date fund. Those are just some of the conversations we're having today as it relates to volatility.

P&I: How can money managers help clients avoid the kinds of behavioral mistakes Jeff referred to?

Mr. Lee: Investors need to show fortitude as volatility picks up and not overreact to events in the market.

What can investment managers do? First and foremost, investment managers can come up with ways that help the client to stick to their policy portfolio. So, as an example, they can offer seamless rebalancing methodologies.

Investment managers can be more transparent about their strategies. By this I mean every strategy has periods when the wind is at its back and periods where you're running into the wind. Overall it's helpful to be more transparent about what environments will be challenging for the strategy.

And if they're forthright with the client about this, it's less likely the client's going to terminate them during a challenging period. Frequently, in hindsight, we see that these challenging periods were absolutely the wrong time to terminate a strategy.

Mr. Ehrlichman: Jeff and Tom both make great points. The main thing that both institutional investors and individual investors should do is think long term. The behavioral bias that you're trying to deal with is the recency bias, meaning what's happened recently seems much more important than what's happened over the long term.

Grounding your long-term plan is so important because regardless of what's happened recently, the exact opposite may occur. That gets to the second mistake that investors make, which is ignoring mean reversion.

Everybody develops a balanced plan, and just like in war where the saying goes, 'No plan survives the first contact with the enemy,' in investing, no plan survives a period of underperformance.

Individuals obviously can be a little more emotional, but I've seen recency bias also take over a board of an institutional plan. They move away from a manager or asset class after five years of underperformance that over the next five years turns out to be the best performance. The best thing managers can do is to have an objective and disciplined and consistent process to navigate the market cycles.

A manager who has such a process should thrive in a volatile and emotional environment. And being transparent with clients and consultants — explaining 'Here are the characteristics we build in, this is when these characteristics are rewarded or punished, here is where we are in the cycle' — I find that that's extremely helpful.

It creates a partnership where we're transparent, we understand one another, we have realistic and well-grounded, authentic evidence of when we're going to do well and when we're not.

Mr. Snyder: We too view working with money managers as a partnership. It's important to really get under the hood, understand the process and look for managers that stick to their guns.

Most of the boards that we're working with want style consistency but not all the time. They want to go outside the box when it makes sense but they want a proven process and a process that is repeatable.

P&I: Paul, tell us more about the equity moves you make in times of increased volatility. Is quality important and are there certain geographies to consider?

Mr. Ehrlichman: We're a bit contrarian. The post-volatility mindset means you want to go to those areas of high dispersion of uncertainty and volatility, and hunt for those companies that will exit the period stronger. The most volatile place is very likely to exhibit lower volatility going forward.

In thinking about sectors and geographies, therefore, going to ground zero of perceived volatility is often the best way to limit downside volatility.

That doesn't mean everyone makes it out alive but that's where we're going to find the hidden gems. Right now it's China, emerging markets, commodities, cyclicals, value stocks in general and banks. There's no shortage of scary places to go but that's where we find the best investments.

Remember, low vol is not magic. You buy low volatility when those stocks are cheap and you buy high volatility when those stocks are cheap. If you're in an economic boom, we would be drawn toward low-volatility stocks.

Quality is of critical importance to avoid value traps. Quality provides that margin of safety for us. Even though quality's extremely expensive today, it takes the volatility out of contrarian investing. It's a really, really important measure.

Contrarians sometimes get some things wrong. We are careful that we go into investments where they are on the creative side of creative destruction and open to new leadership.

P&I: Is value versus growth also part of this analysis?

Mr. Ehrlichman: Value relative to growth is back to its lows in the tech bubble, it's only been here about three times on a relative basis in the last 30 years. So our assumption is that the wind will be at the back of value. Understanding the drivers, why a factor works is very important. It wasn't silliness that caused growth to outperform value and high volatility, it was real. There was a scarcity of real growth, which drove up growth stock multiples. We can also see why and how value would come back.

We are putting ourselves in front of those value stocks that are going to be delivering good relative earnings growth driven by innovation, new products and new markets. We're looking to taking advantage of what is a once-in-a-decade opportunity to add value.

P&I: Is using “low vol” as a factor something to think about?

Mr. Lee: Low-volatility strategies are always worthy of consideration but investors need to be conscious of what they're getting into. Most strategies are constructed around two general themes, a risk metric construction process and a min-variance process.

Risk metric just involves sorting the index by various volatility metrics. Minimum variance looks beyond risk metrics and incorporates correlations among securities. All low-vol factor construction uses some type of concentration limits.

You need to understand that these strategies don't outperform in every situation, namely a down market. For example, the S&P 500 Low [Volatility] Index has underperformed the S&P approximately 15% of the time when the market was negative. So investors have to understand that they can have these downward surprises.

If investors want to avoid these types of surprises, either asset allocation or diversification through the introduction of other risk premiums will provide them with greater certainty of low volatility when they most want it, and that's in a negative market environment.

P&I: Jeff, as a consultant what are you seeing in terms of the introduction of low-vol factor strategies?

Mr. Snyder: Right now it's kind of a wait and see in terms of adoption in the DC space. Most of the conversation is on the flip side, about how do we manage this higher volatility or at least educate our employees to not do the wrong thing.

P&I: Is there a value to holding cash during volatile periods?

Mr. Lee: Long term, I think it's challenging for an investor to hold cash. They are holding risk assets to fund future liabilities, which are growing faster than cash. And investors holding cash also struggle to jump back in and know when the market is bottoming.

If you are really worried about holding cash, there are other strategies available. A very simple one is a disciplined covered-call selling program that will generate cash in a stressful environment and dampen some of the downside volatility. That, to us, would be more prudent than parking money in cash.

P&I: Speaking of covered calls, are there other ways to use derivatives to keep portfolio volatility under control?

Mr. Lee: Yes. Derivatives can and have been used to control portfolio volatility. Historically investors have used long puts or put spreads to control downside risk in portfolios. We are generally not advocates of this approach. It needs to be highly customized to the particular investor and it can lead to a lot of challenging decisions. How do you pay for the downside protection? Do you sell away upside? Our experience has been that most investors become fatigued with the expense and tend to terminate programs, often right before a market experiences challenges.

Instead we are more fans of selling fully collateralized options. We believe in trying to capture the volatility risk premium which is embedded in options. We think it makes more sense to derisk the portfolio and consider being a seller rather than a buyer of the hedge.

P&I: Are you seeing particular types of clients moving in the derivatives direction?

Mr. Lee: Yes. We started working in this direction probably in the 2010-2011 time frame after having many discussions around hedging. The first adopters of this type of strategy were endowments and foundations.

More recently we've seen interest from Taft-Hartley funds that are dealing with particular pension funding issues and mark-to-market issues, as well as public fund investors. We've had a number of inquiries in the high-net-worth channel and we're working on ways to better accommodate that interest.

P&I: Are there other strategies asset owners can use to benefit from increased levels of volatility?

Mr. Lee: Again, we are fans of disciplined, mean-reversion rebalancing. Markets tend to move in cycles, and rebalancing plays to that theme by selling things after strength and buying things on weakness. If you have a diverse portfolio and volatility is high, this can generate material returns.

We are also fans of selling volatility in a transparent, liquid and fully collateralized manner. Our preferred way of doing that is through index options and trying to capture what academic and market research has identified as the volatility risk premium. We like this premium because it can be captured in a transparent, liquid manner and it shows diversification benefits versus traditional assets. It can have a material and positive impact on a portfolio over time.

Mr. Ehrlichman: It's really time to consider something as simple as rebalancing and dollar-cost averaging, though you're pushing the clients into spaces they might be uncomfortable in, meaning selling winners and going into areas that have lagged. Over the long term, that is the most functional, sensible thing that a client can do. When there's a lot of volatility, the return to rebalancing can be much higher. When you get into these extreme periods like we're in now, it's probably a good time to do some rebalancing between emerging markets versus developed markets.

Mr. Snyder: Paul and Tom hit it. Volatility can be an opportunity. The challenge, though, is when you opportunistically use sophisticated instruments, the average employee can get hurt.

To give you an example, in custom target-date funds, do you look at various strategies in order to hedge or to create better returns? We try to bring all these ideas — in partnership with managers — to each committee meeting and between them as well.

P&I: What are the most important concepts investors need to remember regarding volatility?

Mr. Lee: The central topic here has been managing volatility. Many investors look at volatility and are fearful. They intuitively understand that rising volatility generally means more stressful market environments.

Investors need to take a step back and focus on the long term, and not become reactionary or fall into short-term pitfalls and try to shuffle their portfolio to follow some latest fad. As markets evolve there may be better approaches available to them that allow them to achieve their ultimate objectives.

So be open to new ideas. There's a lot of really creative thought going on right now in different areas that maybe in a couple years will become more mainstream.

Mr. Ehrlichman: I was thinking about three things: paradox, asymmetry and mean reversion. Remember that vol doesn't sit in one place and it doesn't behave the same over different cycles. Volatility, the return to low vol or high vol, whatever language you want to use, is unstable and cyclical.

The paradox is that once you're worried about something such as volatility, it is not the time to avoid it because you're probably making a negatively asymmetric move and actually taking on more downside relative to return.

Also, understand that since vol is cyclical, be very conscious of what you're paying to lower your volatility.

Are you paying at the highest price in 20 or 30 years for that basket of securities or that manager's portfolio? And then think about mean reversion.
So paradox, asymmetry and mean reversion: Take a longer-term but dynamic approach to looking at vol and you'll stay ahead of the curve and really have an asymmetric experience with volatility.

Mr. Snyder: Be mindful of the long term, especially working with retirement plan participants. Support committee members in educating [employees] so they make prudent decisions, and focus on the fiduciary responsibilities around the average employee.

Volatility, at least in the near term, is here to stay, and so it's important to always look for investment alternatives and be able to weigh them as a committee and a fiduciary on behalf of your membership.

It's important to talk to the asset managers to understand what they have brewing about new developments and to bring those new developments back to your clients.

This sponsored round table is published by the P&I Content Solutions Group, a division of Pensions & Investments. The content was not written by the editors of the newspaper, Pensions & Investments, and does not represent the views of the publication, or its parent company, Crain Communications.