By John Wasik
CHICAGO, Nov. 25 Sometimes the very name of a
fund sounds like a security blanket if you're a risk-averse
investor. Case in point: "Managed volatility funds" promise some
of the stock market's upside with a cushion on the downside.
This burgeoning class of more than 400 funds is gaining a
gaggle of devotees. There is more than $200 billion invested in
them, according to Strategic Insight, up from $31 billion in
2006. While "managed volatility" isn't well defined, these funds
provide a strategy that dampens volatility over time.
So why worry about market volatility when the market
continues to head higher and both the Dow Jones Industrial
Average and S&P 500 Index keep hitting new highs? Because market
downturns are often unpredictable and the overall risk of loss
never goes away. Yet while volatility funds provide some cushion
from frenetic markets, you pay a price for modest protection.
Take the BlackRock Managed Volatility Investors A fund
, which is one of the largest funds in the category
with more than $600 billion in assets. The fund has gained about
14 percent for the year through Nov. 22. While that's less than
half the return of the S&P 500 during the same period, keep in
mind that the fund is taking long and short positions in the
stock market to hedge risk.
Like most of the managed volatility funds, the BlackRock
fund is an expensive holding. The "A" share class levies
a 5.25-percent front-end sales charge and charges 1.27-percent
annually in additional expenses.
It also costs a lot to execute an active managed volatility
strategy. Unlike a static, umanaged index fund, the BlackRock
fund has a whopping turnover of 324-percent annually, which adds
even more to the heavy expense burden (expenses related to those
transactions don't show up in the expense ratio). That's the
percentage of the portfolio that's bought and sold in a year.
A similar fund - the AllianzGI US Managed Volatility A
- tells much the same story with a 5.5-percent sales
charge and 0.96 percent in annual expenses. The fund's return,
though, is much better than BlackRock's; it's up 23 percent for
the year through Nov. 22.
Since you're paying a steep price for downside protection,
the real test is how well these funds did in 2008, a wretched
year for volatility in which the S&P 500 index lost 37 percent.
The Allianz fund lost 41.5-percent that year while the BlackRock
fund dropped only 27 percent.
One of the flaws in the managed volatility approach is the
promise that you can head off and manage future volatility. Then
there's the conceit of active management that implies that you
can trade your way out of a market decline - or at least brace
the portfolio from larger losses you can't predict.
Don't even pretend that active management will anticipate
future market meltdowns. It's best to keep it simple when
looking at a hedge against stock-market risk. Just reduce your
stock holdings to a comfortable level - say under 60 percent -
and replace them with bonds.
Since bonds pose their own kinds of problems and can lose
money when interest rates or inflation rise, fill your bond
bucket with a bond index fund like the Vanguard Total Bond
Market ETF and the iShares TIPS Bond ETF, which
holds inflation-protected securities that gain when the
cost-of-living index rises.
Why do these funds work as better hedges than managed
volatility funds? The Vanguard fund gained nearly 8 percent in
2008 when just about everything else was tanking. The iShares
fund was down only one-half a percentage point.
And for those frugal investors who don't want to pay too
much for a reliable hedge strategy, there's another advantage:
The bond ETFs are bargains. Vanguard charges 0.10 percent
annually to hold virtually the entire U.S. bond market; iShares
levies 0.20-percent in expenses.
Of course, most investors are probably thinking why even
worry about hedging when the S&P 500 is up 32 percent over the
past year and the U.S. economic outlook continues to improve.
A correction will come, possibly when the Federal Reserve
decides to phase down its bond-buying program. "We are looking
for a near-term decline in the S&P 500 back down toward the
1,770 to 1,780 area before the next major wave to the upside
begins," according to S&P Capital IQ's Alec Young, a
global equity strategist.
Don't wait for the next downturn. Now is the ideal time to
build a hedging combination; not when investors are bolting from
the market during the next correction.