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Q3 hedge fund letters, conference, scoops etc
What should investors do when confronted with market volatility? The conventional wisdom couldn’t be clearer: Ignore it.
“Often the wisest thing to do during periods of extreme market volatility is to stick with the investment plan that you’ve already devised,” argued Bill McNabb when he was Vanguard’s chairman and CEO. Similarly the Schwab Center for Financial Research commentary on volatility states, “Resist the urge to sell based solely on recent market movements…it’s best to ignore the noise and focus on your long-term goal.” If anything, sudden market lurches downward, such as the 2008 crisis and what we have seen in the past several weeks, could present buying rather than selling opportunities, at least for investors with stable finances, long investment horizons – and fortitude.
The conventional wisdom rests on seemingly strong foundations. It is very difficult, if not impossible, to time the price movements of markets. Also, there is a mean reversion in stock returns, so that a crash today is offset to a reversion to the mean later (i.e. prices rebound); hence the paradigm that long-term investors can ride through volatile periods. Finally, it is important to stay invested in the market. JP Morgan retirement research found that just missing the 10 best days in the market during the 20-year period starting January 1, 1998, would have halved performance. Therefore the convention in financial planning practice today is not to manage volatility – it’s to manage investor worries about volatility.
But what if the conventional wisdom is wrong? In a series of papers published in leading finance journals, the economists Alan Moreira of the University of Rochester and Tyler Muir of UCLA reached a very different conclusion. Their forthcoming paper, in the Journal of Financial Economics, found that when volatility increases, investors “should reduce their equity position.”
The volatility-managed approach
Moreira and Muir’s quantitative framework and detailed empirical analysis pose profound challenges to conventional financial planning practice and to conventional economic theory as well. They find that in response to changes in volatility investors should adjust their portfolio exposures to volatile assets to avoid risk but also to increase returns. In essence, investors still shouldn’t time markets in terms of trying to predict where the market is going – so that part of the conventional wisdom remains – but they should and can time volatility.
Their data shows that when volatility spikes, expected returns increase too in the sense that prices fall. However expected returns do not increase enough to offset this increase in risk. The relationship between risk and reward is broken, which is a puzzle. Hence it makes sense for the investor to reduce their position in the risky asset during volatile times, the opposite of today’s conventional wisdom.
But there are other puzzles too. Volatility, though persistent from period to period, is less persistent than downward changes in price, and increase expected returns that follow from a financial shock. In another words, the true buying opportunity is not during the feverish period during a crisis but later, when volatility has returned to normal ranges but prices haven’t yet rebounded. Therefore the strategy doesn’t just avoid risk, it can lead to alpha as well.
In their paper, Moreira and Muir constructed portfolios that take advantage of these “puzzles,” decreasing risk when volatility is high and increasing it when volatility is low. They find their strategy produced an annual alpha of 4.9% as well as an improved Sharpe ratio. Importantly, these results held true even though the strategy would not have avoided Black Friday-type events or other surprise selloffs that mark the beginning of a crisis. Additionally Moreira and Muir pointed out their strategy is distinct from and unrelated to risk-parity portfolio techniques. Though the strategy considers transaction costs, it ignores taxes, a potential stumbling block for individual investors.
Read the full article here by David Adler, Advisor Perspectives
