By John Wasik
CHICAGO, June 29 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
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
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.