The challenging markets of the last decade saw the S&P 500 Index tumble from an October 2007 closing high above 1,565 to a low just above 676 in March 2009, followed by five years of volatile-but-positive returns that once again have markets touching record highs. The long ride down and back up again caused a lot of pain and confusion among all types of investors, Banner says, especially workplace retirement savers. Many defined contribution (DC) plan participants saw portfolios shed 30% or more of their value during the course of the credit crisis, and the experience still troubles American workers.
Today investors thirst for downside protection, Banner says, but they are also faced with the prospect of lengthening lifespans and increasing costs for consumer goods and medical care. These conflicting factors have led to a burgeoning interest in “dynamic investment programs,” he suggests. Investors want portfolio strategies that can pursue needed growth through equity exposure during normal market environments, and then switch, in a timely and efficient manner, to a more defensive outlook during downturn periods.
Sounds like a free lunch, Banner admits. Conventional wisdom says any attempt to time the markets will be fraught with peril—it cannot be reliably done. Service providers, therefore, have largely failed to meet investor demand for truly dynamic portfolio strategies that offer both growth opportunity and reasonable amounts of principal protection on the downside (see “Reducing Volatility in DC Plan Lineups”).
“Historically, the volatility solutions that do exist have been focused on trying to do market timing,” Banner tells PLANADVISER. “The main problem with market timing is that it forces the portfolio manager to take a definite positive or negative view on near-term market performance—to be ‘risk on’ or ‘risk off.’ It’s very much a directional forecast, and we feel it’s really hard to get something like that right with real consistency.”
Even in the case that a portfolio manager successfully predicts an upcoming downturn, it’s another matter entirely to predict how severe or lengthy the downturn may be. There are also the potentially hefty transaction costs to consider. It can be expensive to offload a portfolio’s entire equity allocation, Banner explains, and in cases where a portfolio manager is too sensitive, and converts a portfolio to defensive assets prematurely, significant growth opportunities and principal can be lost.
Other prevailing volatility management solutions involve the purchase of a “tail risk hedge,” Banner explains. “These have usually come in the form of insurance-like derivative products that will kick in when returns are overly negative, and they’re generally more popular for institutional investors,” he says. “The difficulty is that these instruments tend to be quite expensive and they’re often fairly complicated. And when markets are behaving nicely, they can be a real drain on performance. You’re paying a hefty premium for something that isn’t used, and taking on counterparty risk.”
While these twin difficulties—the difficulty of timing the market and the cost of tail risk hedging—have made it challenging for investors to pursue growth while limiting downside risk, Banner says a new approach is emerging that may work better. He outlines the strategy in a study developed with INTECH colleague Vassilios Papathanakos, executive vice president and deputy chief investment officer at the firm.
“We feel that focusing on volatility management, rather than making decisions based on a directional return forecast, is a good answer here,” Banner says. “There isn’t just one way to do this, just as there isn’t a single way to measure volatility. The most important principle is to optimize the portfolio with the objective of minimizing the volatility subject to the constraint of still outperforming the market portfolio by a given target over the long term.”
This philosophy, Banner explains, causes the portfolio construction process to focus on volatility itself as the important metric in deciding how aggressive or defensive to be. As volatility slides up, the portfolio should be tweaked and tailored to suit the new, riskier conditions. Perhaps a number of weak consecutive jobs reports come out and it causes a small uptick in uncertainty in the markets. The manager, seeing this, could move from, say, 70% equity to 65% equity, and can move towards less cyclical assets. The same effect can be achieved within a fully invested equity portfolio by systematically reducing portfolio beta when market volatility rises. It's a more nuanced approach than simply offloading equities when the return forecasts turn more negative, Banner says.
“The portfolio construction process is critical,” Banner adds. “You consider the volatility of the markets and the volatility of the individual stocks. There is a lot of consideration around 'cross-sectional volatility,' which looks at the dispersion of stock returns within a market in a given time period. In the paper, we point to a number of different investment strategies that could benefit from this sort of thinking.”
For example, suppose that the long-term return of the market is forecasted as 8% and the long-term relative return target of an active equity portfolio manager is 3%. It is clear that this implies the portfolio’s longer-term return expectations should be 11%, Banner says. But as he writes in the paper, to continue to target a portfolio return of 11% at all times, even in a period where the market return is strongly negative, is not sensible. Even if a solution is found in the optimization that could keep the portfolio on target, it is very likely that the corresponding holdings will be very concentrated and extremely sensitive to estimation errors.
Instead, Banner suggests a portfolio manager should target returns 3% above the relevant benchmark, rather than the 11% gross long-term growth figure. This will allow the portfolio manager to be agnostic to the level of market return in any particular time period. Optimizing this way, in the low-risk times, the managed volatility portfolio is usually closer to a typical core equity strategy—which is to say fairly aggressive, both in terms of performance and holdings. Conversely, Banner suggests, when the market volatility begins to increase, the managed volatility strategy can follow suit. But rather than triggering a full-scale equity selloff, a volatility-managed portfolio will only become more defensive to the degree necessary to continue targeting the desired level of outperformance.
It's may sound complicated, Banner admits, but the possibilities are attractive. He points to an analysis of the average performance of hypothetical global equity strategies across different market environments included in his study, which shows managed volatility portfolios tend to vastly outperform traditional equity portfolios during down markets. On the flip side, when markets are up, managed volatility tends to far outstrip low-volatility strategies and only trails the core equity strategy by a few percent. This is just the sort of performance investors want, Banner says. After 2008 they're willing to sacrifice a few percent on the upside to get principal protection mechanisms in place.
“The other important realization is that a portfolio doesn’t just have to be risk on or risk off,” Banner says. “There are levels of exposure along the way, depending on the point-in-time assessment of the market volatility. So managed volatility is an investment style rather than a switch. It’s like a light dimmer. You can slide from very bright to half bright. You don't need to turn out the lights.”
An executive summary of the analysis, “Smart Volatility Management in a Risk On/Risk Off World,” is available here.