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Avoiding Volatility Is Even Harder Than It Looks in This Market

Avoiding Volatility Is Even Harder Than It Looks in This Market

(Bloomberg Businessweek) -- For investors who aim to hold down the volatility of their investments, this has been a very unsettling year. Not only have markets been wild, but many classic havens proved not to be so safe in the face of the coronavirus pandemic.

Take one of the simplest examples: buying stocks that in the past have shown low volatility. The S&P 500 Low Volatility Index—which measures the 100 steadiest stocks in the S&P 500—has lost more than 16% so far this year, compared with a loss of about 7% for the broader gauge. The low-volatility companies were hit slightly harder during the equity rout from Feb. 19 to March 23 and have recovered less than the market since then.

Or consider another approach to smoothing returns known as risk parity. In this strategy a money manager builds a highly diversified portfolio that includes stocks, bonds, and other assets but can use leverage—in essence, borrowed money—to aim for a specific level of volatility and, hopefully, higher returns. The idea is that even with the leverage, you’ll get some safety from the fact that stocks and bonds often move in the opposite direction.

During the market drop, an S&P benchmark for risk parity strategies aimed at a volatility of 10%—which is lower than a pure bet on equities—declined less than the stock market. But during some of the worst moments of this year’s crash, bonds went down too, giving some risk parity investors an unpleasant surprise.

“Risk parity’s dependency on an assumed relationship between stocks and bonds is obsolete, because that relationship is obsolete,” says David Bahnsen, chief investment officer of the Bahnsen Group, based in Newport Beach, Calif.

Both the risk parity and low-volatility stock strategies face the same basic challenge, which is that investments haven’t behaved like they used to. Fixed income came under pressure in mid-March when investors were scrambling for cash anywhere they could get it, including by selling normally reliable bonds. The U.S. Federal Reserve eventually stepped in to pump liquidity into the market, which stabilized bonds.

As for low-volatility stocks, they had for years been regarded by many as replacements for bonds. During an era when fixed income offered very low yields—and sometimes even negative ones—some investors felt they had no alternative but to shift money into equities, starting with the safest first. Over time, those historically stable stocks have become more expensive. “That dislocation is still there—the bond proxies are trading at 25 times earnings,” says Andrew Lapthorne, global head of quantitative strategy at Société Générale SA. By comparison, the stocks that behave least like bonds are trading at nine times earnings.

Trouble is, those stocks “didn’t behave like bonds into the crash, they behaved like equities,” Lapthorne says. “If you’re buying the stock on the promise it behaves like a bond, well, it’s not. You can hardly consider an instrument which falls 30% in a matter of days low-risk.” The potential damage from the pandemic is so widespread that all sorts of companies were hit during the sell-off. And as stocks have climbed back, a huge chunk of the gains has so far gone to big tech companies—the kind of growth stocks that don’t generally make the low-volatility list.

All this illustrates just how hard it is to predict what will actually be volatile and what won’t. Bahnsen’s advice for those who need to lower volatility is to keep things simple and move into less risky asset classes, even if that means accepting lower returns. That could include buying Treasury bills or short-term, high-grade corporate bonds.

Some stockpickers aren’t writing off defensive strategies. “We are not yet out of the crisis mode,” says Solomon Tadesse, SocGen’s head of North American quantitative equity research. SocGen has been recommending a switch out of the Russell 2000 small-stock index, which the firm sees as including a lot of weaker companies, and a move into companies with dividends and strong balance sheets—that is, comparatively low debt. “The rule is, in a crisis, avoid leverage,” Lapthorne says, speaking of companies’ debt. “And that applies now.”
 
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