Risk is a Ten Letter Word

Investors over the recent past not only know about volatility, they likely have the scars to prove it!

Exchange-traded funds (ETFs) are well known for their low cost, tax efficiency and diversified exposure to markets, asset classes, sectors, commodities and industries. Less well known is that ETFs provide neat packets of stable risk that can not only be used to construct tailored portfolios but also to control risk easily and more effectively than ever before.


Case for more volatility

Capital market volatility threatens the adequacy of RRSPs, the solvency of defined benefit pension plans, the patience of clients and the sanity of advisors. Systemic risk from deregulation, interconnected global financial and banking structures exacerbated by an explosion in derivatives use, high frequency trading, and advances in information technology suggests that “returns are likely to remain highly heteroskedastic, showing periods of consistently high and low volatility,” says Ioulia Tretiakova, Manager of Quantitative Strategies, PŮR Investing Inc.. Nothing in currently proposed banking reform legislation suggests otherwise. The problem is that capital markets dislike uncertainty most of all.

Even if you believe that the credit crisis was a “once-in-a-lifetime” aberration, advisors have a duty to clients to protect them from it.


Managing volatility

Diversification theory suggests selecting assets that don’t move in the same direction at the same time (uncorrelated). This is smart because if one asset class is zigging (i.e. Canadian equities) while another is zagging (i.e. gold) the volatility of the combined portfolio will be dampened. But very much like a balance sheet, these relationships are more like a snapshot than the dynamic of an income or cash flow statement that show changes between periods. Two important things to remember:

• correlation between asset classes can and does change over time;
• market volatility can over-ride correlations.

I mention these caveats because they are too often ignored or forgotten by investment professionals and retail investors alike. The table below shows the correlations between several asset classes represented by ETFs. Because they are already individually diversified, ETFs provide reliable risk that can be assembled into effective portfolios. Low and negative correlations are the best combinations for diversification.



Diversification failed to protect portfolios during the market meltdown. There is little protection against crises of confidence and lack of liquidity.


This chart illustrates the development of the U.S. credit crisis as represented by the interest rate spread between U.S. Treasury bonds and corporate bonds. As confidence deteriorates, lenders demand higher yields to hold any debt instrument other than Treasuries, so the spread opens up. The shaded area shows the volatility of the S&P 500 – 126 day moving average. Volatility remained stable until mid-2007 before spiking in 2008-2009.

Market volatility is a big challenge for investors and their advisors. Let’s assume a 60% stock 40% bond portfolio is considered appropriate for an investor in 2005. As the stock market rose in 2006 and 2007, the portfolio sells stocks and buys bonds to rebalance to the 60:40 fixed asset mix. This seems reasonable because we’re supposed to “sell high” and “buy low”, right? But is the “risk” of the portfolio the same in 2008-2009 as it was in 2005? Clearly it is not.

A better solution would be to maintain the “risk” represented by the 60:40 asset mix consistently through periods of market volatility. The risk of a portfolio should represent the risk tolerance of the investor that doesn’t change in good or bad markets. If “12” represents the risk of a 60:40 mix in 2005, the “risk” of the portfolio would have spiked to over 30 in 2008-2009! To keep this portfolio at 12, equities would be 20% and bonds 80% in mid 2008. An alternative less disruptive to the mix would have been to buy the iPath S&P 500 VIX Short Term Futures ETN (VXX). Either approach would have saved serious money for investors.


Sophisticated

The idea of managing to a consistent risk is a sophisticated institutional approach on two levels. Firstly, the idea of budgeting risk is a concept used only by the largest pension funds and institutional pools of capital. No mutual fund in Canada uses this strategy as far as I know. Secondly, managing volatility is a cutting edge idea. The availability of volatility ETFs like VXX and VXZ (the mid-term version of VXX) makes these tactics available to individual investors. Hedging long positions with short or inverse ETFs is also a tactical option, but that is a subject for another time.


Summary

ETFs offer the potential to bend and shape risk in ways previously available only to institutional portfolio managers with hundreds of millions under management. This capability comes with the responsibility for advisors to “up” their game, but the payoff will benefit their clients and their practices.