Mark Peterson discusses the benefits — and importance — of managing downside volatility.
Since last August investors have become reacquainted with volatility. The reemergence of market turbulence after a prolonged period of calm is the result of both short- and long-term factors. The short term include the withdrawal of accommodation by the Fed, a sharp rise in the dollar (itself a form of monetary tightening), a deceleration in the global economy and growing tremors in credit markets. The long-term factors include the decline of the old emerging markets growth model, fiscal strains in most developed countries and longer-duration bond portfolios. Finally, rising correlations between previously less correlated markets are further complicating the process of portfolio construction.
For many investors, a solution is to attempt to time the market, in other words, move to cash and wait out the turmoil. Attempting to exit and re-enter markets is always tempting, but the preponderance of evidence suggests that market timing is difficult and rarely adds value.
Instead, investors need to consider other strategies than one dependent on executing a one-way bet on the market’s direction. One potential approach is emphasizing funds and instruments with low “capture ratios.” In other words, constructing a less volatile portfolio where returns, both in up and down markets, are more muted. Historically, a portfolio with a capture ratio below 1 (a 1 would match the market; less than 1 would mean the portfolio returns are less than the market at large in both up and down periods) may not only have limited portfolio volatility, but may have actually outperformed since the peak of the last bull market in 2000. As we demonstrate, during this period, a capture ratio of roughly 75% would have resulted in the optimal terminal value.
The benefits of downside risk mitigation are not simply a statistical artifice of the last bull market but are grounded in simple math. Compounding returns requires bigger gains to make up for drawdowns. This paper discusses how, given this reality, strategies that manage downside volatility, even at the cost of giving up some gains, have historically been additive.
Investors looking to adopt this approach may consider several options. Flexible mandates, minimum volatility and dividend funds are all strategies that have historically had a capture ratio below 1. Funding these strategies with traditional cap-weighted exposure may help mitigate portfolio level volatility.