Clark: Managing Volatility With XVZ

March 17, 2014

Investors need to deal with volatility carefully, and a few ETPs can help, Sean Clark says.

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article features K. Sean Clark, CFA, chief investment officer of Philadelphia-based Clark Capital Management.

Volatility of return may have an important, perhaps overlooked, effect on the returns investors actu­ally earn. The chart below illustrates the return of the S&P 500 Index for a 15-year period, during which time the index had a cumulative return of 98.54 percent.

However, how many investors stayed invested for that whole period and achieved that return? Money flow data from Morningstar as well as Dalbar indicate that investors made bad decisions again and again during this time period.

We believe that the culprit causing investors to bail out of the market is volatility. Volatility and the emotions associated with it stand between investors and their desired financial goals. It’s important to address this reality, and tools such as the iPath S&P Dynamic VIX ETN (XVZ | B-22) can help.

We’ll get to XVZ and another volatility-related hedging choices, but first let’s look a bit more closely at volatility and its effects on a portfolio.

To begin, investors all too often focus on the average returns of an investment. In fact, investors don’t receive the average return; rather, they receive the compounded result of the return stream.

In other words, average return does not equal compounded returns. The difference between the average and the compounded returns is volatility, and the greater the volatility, the greater the dif­ference between the two.

The chart below also illustrates this concept. The S&P 500 had an average annual return of 6.58 percent for this 15-year period. However, investors only realized a compounded annual return of 4.68 percent.

This difference has large implications for investors. If an investor had (hypothetically) received a 6.58 percent com­pounded return, the cumulative return on the investment would have been 160.22 percent, compared with the actual return of 98.54 percent.

S&P_500_1998_To_2013

It’s easy to see how volatility is potentially one of the biggest—if not the biggest—impediments to investors achieving their desired outcomes. We recognize that successful investing requires taking some risk and that volatility can’t be eliminated entirely. Therefore, we believe that investors should adopt a low-volatility equity strategy that seeks to minimize this risk.

We believe a variety of vehicles and approaches can help investors achieve lower volatility. First and foremost, a well-diversified portfolio across different asset classes has historically been shown to help reduce investment volatility.

Diversification among investment methodologies has also been demonstrated to be an effective way to manage volatility in a portfolio. For instance, combining strategic and tactical allocations may help to spread out the risk in different market regimes.

 

 

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