Volatility and volatility managed strategies
Managing volatility, in essence, is all about managing your exposure to risk. After all, if an investment or market is considered to have a low level of volatility, it typically indicates that its price tends to be relatively steady over time. However if it’s to be volatile, it means that its value can fluctuate dramatically. Ultimately the greater the potential volatility of an investment – the riskier it is
Generally speaking, most assets and markets, even those not considered volatile will naturally over time witness their value fall and rise, and sometimes sharply so. Therefore being able to navigate your investments through such periods is vital.
When it comes to investing, the real issue in regards to market volatility is not just about losing money but the effort required to regain your losses if you do take a hit. To put this in context, if your portfolio lost 50% of its value, this means it would subsequently need to achieve a 100% gain just to get back to where it started.
Investors keen to ensure they don’t potentially suffer any big losses as a result of unpredictable market behaviour, may wish to consider a professionally managed solution, such as funds which incorporate volatility mitigation.
What are volatility managed strategies?
Volatility managed strategies are funds which adjust their asset allocation in anticipation of, or in response to, certain market events. These investment vehicles, sometimes dubbed as multi-asset risk-targeted, outcome-oriented solutions or solutions-based funds, attempt to replace an asset manager’s traditional goal of achieving excess returns over a chosen benchmark, such as the FTSE 100. They are designed to have a more direct connection to an investor’s objectives, by targeting and managing a level of risk they are comfortable with.
They look to deliver a more consistent risk/return trade-off, sacrificing some potential upside return in exchange for a smoother investment ride but such an outcome can never be taken for granted.
How do managed volatility strategies work?
If a fund’s risk model – the system it uses to manage market ups and downs - signals that a period of sustained period of market stress is imminent, a managed volatility strategy can be de-risked by altering its asset allocation to a blend of lower-risk assets. For instance it could move to a lower weighting in equities in favour of traditionally less risky assets such as government bonds. Subsequently, during periods of market calm, they will generally revert back to their original asset mix. Fund managers can employ a number of tactics to tackle market volatility, but generally speaking, there tends are two methods:
They can use what is referred to as a volatility-cap mechanism. Here as the name suggests, they have a maximum volatility threshold – in others words, the fund manager will ensure a fund does not breach a particular volatility limit.
A fund manager may also target a particular level of volatility - to ensure it remains at a relatively constant level over time.
To complement such strategies a manager may also use a so-called ‘stop-loss mechanism’ whereby they attempt to ensure – but importantly cannot guarantee – that their fund never exceeds a certain level loss. For example, they will attempt to make sure their portfolio does not lose, say any more than 5%, over a certain time horizon.
The bottom line
Managing volatility is essentially about managing against potential losses. As highlighted - a 50% fall means a 100% gain is subsequently required to get you back to where you began. When it comes to market volatility it is always worth bearing in mind the old saying that successful investing is about “time in the market, not timing the market”. Successfully timing the market i.e. getting out just before a fall, and back in just prior to a recovery, is a task even the most seasoned professionals struggle to achieve.
But volatility managed strategies can potentially help preserve investor’s money during periods of uncertainty as the asset allocation for a volatility managed strategy can be adjusted in anticipation of, or in response to, market events.