By John Wasik
CHICAGO, June 29 (Reuters) - Portfolio volatility is your sworn enemy if you're nearing retirement or market downturns make you nauseous. But if you're a buy-and-hold investor - and believe that stock market risk diminishes over time - you still need a new course of action.
With high-frequency robotic trading, exchange traded funds and global news hitting markets at the speed of light, there's no reason to believe volatility is going away.
Recent research by Lubos Pastor of the University of Chicago and Robert Stambaugh of the University of Pennsylvania confirms this view. In a forthcoming piece in the Journal of Finance, they examined 206 years of stocks returns and confronted the conventional wisdom that stock risk declines over time.
"We find that stocks are actually more volatile from an investor's perspective," they concluded, citing "uncertainty about future expected returns" as a major factor. The Lubos-Stambaugh paper seeks to refute earlier research by luminaries such as Jeremy Siegel, also of the University of Pennsylvania, who claimed that stock market risk is reduced over long holding periods. His book "Stocks for the Long Run" was a bestseller before the dot-com crash.
In the wake of the 2008 meltdown, there's ample evidence that volatility has been increasing. You need only look at the calamity of the past few years to know that conventional investing has been a gut-wrenching roller-coaster ride.
The CBOE volatility index (VIX), which measures short-term volatility of S&P stock index options, has hit its highest level in the last 20 years three times since 1998, and has closed above 25 - a notable high point linked to market declines - five times during that period.
One way to reduce market risk is to lower the overall allocation of stocks in a portfolio. If that doesn't appeal to you, add specialized exchange traded funds to the mix. You can buy inverse ETFs from the PowerShares, Direxion or FactorShares groups, for example, that gain when stocks lose. Have a large position in single stocks, particularly those of your employer? Buy put options on them to protect against downside risk.
Also keep in mind that asset classes that typically don't move together can fall off the cliff at the same time during an extreme market crisis. That was the case in 2008 with U.S. stocks, emerging market stocks, commodities and real estate stocks, or REITs. This unexpected correlation blew the traditional thinking of Modern Portfolio Theory diversification out of the water.
Many portfolio managers have developed an early-warning system that tells them when an asset class is due for a fall. Under a "tactical asset allocation" model, they will rebalance into less volatile investments when they see a market storm brewing. Another approach is "Adaptive Market Hypothesis," which combines behavioral investing, derivatives and active management to target and reduce volatility.
One fund, the Natixis ASG Global Alternatives, managed by AlphaSimplex in Cambridge, Massachusetts, employs hedge fund-like strategies to "maintain a targeted level of volatility." Jerry Chafkin, a fund manager and president of AlphaSimplex, says his firm uses algorithms to monitor market activity daily - and makes adjustments automatically to stay within a preset volatility range.
Chafkin's fund held up during the market tsunami in late 2008 - it was launched Sept. 30 of that year - and early 2009. It posted only a 0.62 percent loss in the first quarter of 2009, compared with a negative 11 percent for the S&P 500. Year-to-date, though, it is down 3.80 percent, in contrast to a 7.04 percent total return for the S&P.
"Volatility was unprecedented in the most recent financial crisis," Chafkin told me. "And we expect the volatility of volatility to continue. But now instead of knowing how much risk to expect, investors have uncertainty."
Managing volatility isn't free, though. The more involved a hedging strategy - especially those involving "absolute return" funds that seek positive returns in any market - the more you'll pay a fund manager. These specialized funds also can lag when the market is flat or rising, and can be costly. The expense ratio for the ASG fund (A class) is 1.60 percent annually with a 5.75 percent sales charge, for example, compared with 0.55 percent for the average exchange traded fund. While that's a relative bargain for most hedge funds, it's quite pricey for an ETF.
If you don't want to buy an off-the-shelf fund, you'll need to find an advisor who understands derivatives. Any sophisticated hedging strategy should be done with a trained registered investment adviser, certified financial planner or chartered financial analyst, since you can still lose money with these strategies.
You can also find pre-allocated portfolios at sites like MyPlanIQ.com and Folioinvesting.com. But if you come from the ultra-risk-averse camp, you may not even need them if you can reduce your stock holdings and replace them with single U.S. Treasury, municipal or inflation-protected bonds. They are among the simplest answers to market volatility and are generally the most effective if you don't want an active strategy to fully replace your buy-and-hold objective.