Just Close Your Eyes?

The Brexit induced volatility we are currently experiencing has forced the issue of volatility mitigation back to the forefront of investors’ minds.  As I think through the problem, if you have a portfolio that includes long-only equities, volatility mitigation, outside of a bond portfolio, can be done in three ways:

  1. 1. Hold some long volatility strategies
  2. 2. Hold significant zero correlation strategies
  3. 3. Close your eyes

I advocate for a mix of 2 and 3, which is worthy of some explanation. Let’s start with strategy number 1, going long volatility. The problem here is investors pay way too much for insurance in the financial markets. Being long volatility has a negative expected return (see VXX), so much so that it is unlikely you’ll keep the strategy long enough to receive the payoff, and if you do, you are unlikely to sell at the right time when the payoff happens. You have to time these strategies perfectly, otherwise you are almost guaranteed to lose money. The positive to long volatility strategies? When markets are volatile they will rise and they are just about the only thing guaranteed to do so.

What about strategy #2? These types of strategies include market neutral and managed futures. They carry very little market correlation, so they are able to make money when markets are falling. The downside? They carry very little market correlation, and so they can also lose money when markets are falling. “No correlation” is not “negative correlation”. Additionally, you have to have significant exposure to these strategies for them to actually impact your overall portfolio. When the low correlation works in your favor this is great, when it doesn’t it can be frustrating. Which leads to strategy #3…

Close your eyes? What kind of strategy is that? I’ll show the magic of volatility mitigation via “closed eyes” with two charts from earlier this year:

Chart 1: High Volatility – Daily FrequencyBlog_chart1

Chart 2: Low Volatility – Quarterly FrequencyBlog_chart2

Amazing, right? Had you only looked at your quarterly statement (still too short of a time frame to make meaningful decisions) you would have thought “what a boring quarter”. But had you looked at your daily portfolio values, at best you would have been an anxious mess, and at worst, might have let fear get the best of you, resulting in selling everything at the beginning of February. The same is mostly true looking at the markets on a daily basis during Brexit. To be clear, I’m not advocating being blind to market moves. We have seen equity markets experience numerous long-term drawdowns that you wouldn’t want to ignore. What I’m advocating for is thoughtful portfolio construction (see point #2) and then letting your portfolio construction play out over years. Not months, not days, not hours, but years.