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“Markets can remain irrational longer than you can remain solvent” is a famous line on Wall Street. The underlying premise for the quote is that your analysis that markets or sectors are overvalued or undervalued can be correct in the long-term, but so wrong on the timing that you must manage risk appropriately.

Research and experience shows us that the average investor’s tolerance for risk is higher when markets are strong or benign, but that self-assessment of risk tolerance will often be challenged as market conditions change. While a buy-and-hold approach of a fixed allocation appears to work best over the long-term, investors’ emotions can result in sales at the bottom and purchases at the top of market cycles, often resulting in poor outcomes.

For instance, during normal market sell we routinely get a small number of calls asking to transition an account to cash immediately. The rationale was usually something along the lines of “I saw this movie in 2008 and I don’t want to see it again!” This was a dramatic pivot from the calls and questions just a few months earlier, when investors asked “Why don’t I don’t own more in XYZ Technology Company?”

Fear and greed are powerful emotions. In response to investors’ propensity to make emotionally driven decisions, the investment management industry has come up with a number of methods to help investors manage shorter-term risk—but most of these approaches still fail to deliver a defensive stance with ample upside capture.

However, new options are emerging for individual investors that were previously reserved for the domain of institutional and ultra-high-net-worth investors. We’ll explore the merits of one of these options—Volatility Targeted Portfolios—in what follows.

Volatility Targeted Portfolios: An Evidence Based Approach to Portfolio Risk Management

Acknowledging the limitations of managing investor behavior with traditional asset allocation and the repeat failing of a fully tactical approach, another approach for investors concerned about the impact of market volatility on their portfolio is a Volatility Targeted Portfolio.

Aligning Portfolio Risk and Risk Tolerance Across Differing Market Conditions

With a Volatility Targeted Portfolio, asset allocations are adjusted to maintain a volatility target that is acceptable to the investor. So, unlike traditional asset allocation, which keeps the dollar weights the same—e.g., for every $100, put $60 in stocks and $40 in bonds—the dollar allocation across stocks and bonds in the Volatility Targeted Portfolio will vary as needed to keep volatility as close to the target as possible. That means when volatility in stocks goes up, the portfolio will sell stocks and buy bonds as needed to maintain the same volatility target.

This strategy benefits from the observation that while returns are not predictable, research shows that risk, as measured by volatility, is predictable.

Volatility tends to be auto-correlated, meaning recent volatility tells you a lot about the volatility of the immediate future. When volatility is high, it tends to stay high; when volatility is low, it tends to stay low. The result is that the portfolio will have more exposure to equities during periods of calm and less amid times of turmoil.

You can see how the difference between a traditional approach and a volatility targeted strategy plays out in the hypothetical scenario shown in Figure 1. In this example, the asset allocation in the 60/40 portfolio was the same in Period 1 as in Period 2, but the total portfolio risk (as measured by volatility) varied significantly between the two years. Contrast that with the Volatility Targeted Portfolio over the same two years; the observed asset volatility mirrors the 60/40 portfolio in Period 1 and Period 2, but the asset allocation between equities and fixed income are adjusted to meet the 8% volatility/risk target set by the investor.

Figure 1: Comparing Asset Weight and Volatility of the 60/40 Portfolio v. Volatility Targeted Portfolio

*Assumed correlation -0.2

Reducing Risk Through Dynamic Risk Management

When this strategy is implemented, Volatility Targeted Portfolios may act as a hedge against market downturns. As market volatility increases, the strategy will shift higher-volatility assets (equities) into lower-volatility assets (bonds)to help lessen the impact of undesired risk on the investor’s portfolio. Put simply, as the world gets riskier the portfolio gets less risky; as the world gets safer, the portfolio gets more risky.

Potentially Providing Higher Risk-Adjusted Returns

Research has found that using Volatility Targeted Portfolios can reduce risk without substantially reducing return. Among the most notable of this research was a 2016 paper by Yale School of Management’s Alan Moreira and Tyler Muir entitled Volatility Managed Portfolios, which compared portfolios that leverage forward projections of volatility to a buy-and-hold strategy. Their results are show in figure 2, which plots the cumulative returns from a buy-and-hold strategy versus a volatility targeting strategy for the market portfolio from 1926-2015. As you can see, the volatility targeting strategy tends to perform better during highly volatile “disaster events” such as the Great Depression and the recent recession than the buy-and-hold strategy.

Figure 2: Cumulative Returns to Volatility Timing for the Market Return

Source: Volatility Managed Portfolios, Alan Moreira and Tyler Muir, 2016.

Not a No-Risk Strategy

Volatility targeting reduces risk by limiting a portfolio’s downside exposure while still capturing growth on the upside. Sounds like a win-win, right? Not so fast.

Mind the Gap—One Risk Unique to Volatility Targeted Portfolios

Volatility Targeted Portfolios are subject to a peril called Gap Risk. When volatility is low, the allocation to equities will be increased to reach the portfolio’s volatility target. That means that during a very low period of volatility, an investor with a moderate or low risk target may end up with an aggressive equity allocation. A sudden spike in volatility and corresponding decline in equity prices will leave the Volatility Targeted Portfolio more exposed than a traditional asset allocated portfolio.

Falling From the Gap—Painful but Short-Lived

While the market has recovered quickly from most historical gaps, such risk can be meaningful if the gap corresponds to a period where investors need funds from the portfolio.

Figure 3: Draw-down size and time to recover by volatility regime.

Volatility Observed

Largest Single-Day Drop

Time to Recover

High Risk

Volatility Over 20%

-20.47%

10/19/1987

91 days

Normal Risk

Volatility Range (10% - 20%)

-6.87%

10/27/1997

5 days

Low Risk

Volatility Below 10%

-0.78%

4/24/1964

5 days

Source: WEAS/Bloomberg—data from 1927-2017

Volatility Targeted Portfolios are also more actively traded than traditional asset allocated portfolios. Depending on the investor, such activity may generate unwanted taxable gains and/or transaction fees—these costs should be considered before investing in such a portfolio.

In Sum

For investors sensitive to volatility, using volatility targeting to manage portfolio risk provides several key benefits:

  • Portfolio risk, as measured by volatility, will be better aligned with investor risk tolerance across marketing conditions.
  • Since volatility is auto-correlated it creates the possibility that a Volatility Targeted Portfolio could out-perform a buy-and-hold approach.
  • Sequence of returns risk can be lower since the portfolio will have more low-risk assets during period of high volatility.

This kind of portfolio management takes a deep understanding of risk management and the extent to which investing risks fluctuate and correlate. It’s important to rely on a professional investment management team to deploy such strategies to manage the momentum overlay and correlation overlay required. Paired with a strong financial plan that incorporates a tax-efficient cash flow strategy, employing a Volatility Targeted Portfolio could deliver strong returns while maintaining your preferred risk tolerance.

 

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

Asset allocation does not ensure a profit or protect against a loss.

No strategy assures success or protects against loss.

These are hypothetical examples and are not representative of any specific situation. Your results will vary. The hypothetical rates of return used do not reflect the deduction of fees and charges inherent to investing.

This article was originally published on Forbes.com.

Jim Cahn

Jim Cahn

EVP, Chief Investment Officer | Business Development

Jim Cahn’s philosophy on investing is centered on providing clients with cost-effective, well-diversified portfolios. He has appeared on CNBC, Fox Business and Bloomberg TV and writes a monthly column for Forbes.com.