The standard approach to investing is to accept that higher returns mean greater risk and regard a diversified portfolio as the frontline defence against volatility.
But the last decade has shown that neither of these cornerstones is failsafe. In the global financial crisis (GFC), the S&P/ASX 200 Index tumbled from 5700 in May 2008 to 3166, within 12 months. Falls of this magnitude spooked both advisers and retail investors, especially when diversification failed to protect even the most sophisticated portfolios.
Fast forward 10 years and volatility continues to be a highly emotive issue for investors. That’s not surprising. Financial planners know all too well that the pain of losses is often felt more keenly than the joy of gains.
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Tony Davison, a senior financial planner with Henderson Maxwell, says “The majority of investors can’t handle volatility – they don’t have tolerance for a rough run”.
Davison’s views are backed by the findings of the 2017 ASX Australian Investor Study conducted by Deloitte Access Economics. It found Australians are risk averse by global standards, and nearly 70 per cent of all local investors are seeking stable, reliable or guaranteed returns.
Tony Catt, financial planner and director of Catapult Wealth, says volatility is of particular concern among investors in the drawdown phase. He explains, “A GFC type of event can cause a heavy erosion of capital.” But the ASX study found the appetite for stability is not unique to the older generation. More than 4 in 5 (81 per cent) of investors under age 35 – the next generation of advice clients – are also seeking stable returns.
Risk isn’t paying off
While sharemarkets are volatile by nature, investors don’t merely have to hang on for the rollercoaster ride, according to Andrew Hair, chief executive of Acadian Asset Management (Australia), a global leader in managed volatility investing. He says there is a way for advisers to help their clients chart a smoother course and the solution lies in a managed volatility strategy.
The smoother course doesn’t have to come at the expense of returns.
“Evidence shows that risk is mispriced in the market, so why take investment risk if you don’t need to?” Hair asks. “It is possible to build a portfolio that will help investors achieve market-like returns but with significantly lower risk than a capitalisation-weighted index.”
A different way to think about portfolios
Managed volatility strategies centre chiefly on the ‘low-volatility anomaly’, whereby low-risk shares tend to outperform higher-risk equities on a risk-adjusted basis over time. It’s a theory Hair says is “increasingly accepted in the financial community, backed by a wealth of empirical evidence to show it exists in equity markets around the world”.
Hair explains how this relates to advice clients, saying, “Investors often focus on total returns, rather than asking ‘What risk am I taking to get those returns?’ Managed volatility portfolios can give a better return for the level of risk being taken – and that is a very different way to think about a portfolio.
“Acadian’s Australian portfolio for instance, is benchmarked against the S&P/ASX 300 Accumulation Index. So we’re trying to achieve that level of return over the long term but dropping risk significantly compared with the index.”
Acadian launched its first managed volatility fund in 2006, and its long-term track record firmly demonstrates that the combination of market-like returns coupled with low risk, can – and has – been achieved.
‘Exploit the anomaly’
Unlike an indexing strategy, which essentially takes market-like risks to earn market-like returns, Acadian takes an active approach to stock selection, addressing a comprehensive range of factors to counter the potential downsides of low-volatility investing.
Katrina Khoupongsy, vice-president, portfolio management and research at Acadian, manages a number of the firm’s $1 billion worth of Australian equity portfolios that are taking advantage of the low-volatility anomaly in the local market.
She explains Acadian’s stock selection process: “We could exploit the anomaly very simply. But that could produce a subpar portfolio – one that’s not sufficiently diverse, that could be expensive, and where stocks have low-volatility characteristics, though at the expense of attractive qualities such as value, quality, growth, and momentum.
“We know that the price paid for stocks [affects] returns. So if valuation isn’t considered in a managed volatility strategy, the result can be a very expensive defensive portfolio. Similarly, some low-risk stocks display bond-like characteristics, so we look at how they are going to behave when interest rates move. And we also consider the correlations between different stocks.”
Khoupongsy describes the outcome as “a high-quality portfolio that isn’t too expensive, compared with the market, with good growth and technical characteristics”.
A smoother glide path for returns
For financial planner Davison’s practice, a managed volatility approach makes sense.
“Managed volatility products play an important role in our portfolios, occupying 5-7 per cent of our weightings, and we are very comfortable with them,” he says.
In fact, he says his clients experience a number of benefits from managing volatility and notes it’s not something that can be built by non-professionals.
“It provides a smoother glide path for returns. But it also adds diversification, and the technique managed volatility funds use is virtually impossible for a [retail] investor to replicate on their own.”
The results for the ASX study demonstrate investors from a variety of demographics desire a smooth ride through cycles and Acadian’s Hair says when that’s paired with market-like returns, it becomes a compelling proposition.
“If you can drop the level of risk you take, and still get a market-like return, then you’re getting a much better risk-for-reward ratio,” he says. “Combined with a long-term outlook, that makes managing volatility a strategy that could suit all investors.”
