3 Views On Managing Rising Volatility

With the Fed posturing to set up its first rate hike in nine years, investors need to figure how to manage the rising volatility.

Managing Editor
Reviewed by: Olly Ludwig
Edited by: Olly Ludwig
With financial markets at or near all-time highs, it’s a good time for investors to line up their ducks and figure out how to deal with the volatility that’s likely to manifest as markets lose their upward momentum. ETF Report asked three advisors who are part of our “ETF Strategists Corner” how they were preparing for the day the markets shift gears and possibly turn lower.
All-time price highs, on their own, are not worrying so long as they’re accompanied by reasonable valuations. But that’s where investors may be stuck between a rock and a hard place with a traditional asset allocation.
The rock is equity valuations. The “Buffet Indicator”—defined as total market capitalization divided by GDP—places equities in the 97th percentile of quarterly readings since 1962.
The hard place is the presently basement-level interest rates. Nominal interest rates are a terrific tool to forecast forward bond returns. With 10-year rates near 2%, we can expect 10-year Treasurys to return approximately 2% a year, before inflation, over the next decade.
This is almost the exact opposite environment of the early 1980s, which led to one of the largest 20-year rallies in stocks and bonds the U.S. has ever seen.
That is not to suggest that the next 20 years will be the worst the market has ever seen, and markets need not necessarily even crash from these levels. However, both theory and empirical evidence are aligned that forward return expectations for stocks and bonds are moderate at best for the next five to seven years.
With this forecast, we’re currently consulting with advisors about diversifying their portfolios toward high-carry asset classes. We define “carry” as the expected return of an asset assuming market conditions—including the asset’s price—stay the same. For example, this might be the yield-to-maturity of a bond or the dividend yield of a stock.

By focusing on high-carry asset classes, we can skew our portfolio’s origin of return toward less-volatile sources like income and reduce the reliance on interest-rate- and valuation-sensitive returns from price appreciation.
Beyond traditional income-generating asset classes, we believe investors should consider incorporating nontraditional income generators and ETFs, including:
As of the end of the first quarter of this year, ETFs we use representing this universe had an average trailing 12-month dividend yield of 5.99%. Over the prior three years, dividend yield accounted for, on average, 77.64% of their total return, skewing returns toward a much less volatile source than price growth.
While we believe that tilting total return sources toward high carry can aid investors in growing their asset base in tomorrow’s potentially low-return environment, we recognize that many of these asset classes have high carry due to their risky nature.
Therefore, we embrace a flexible approach, incorporating only those asset classes exhibiting positive momentum and allocating in a manner that favors asset classes exhibiting the greatest carry per unit volatility.
With these rules, we favor positive- trending, higher-risk-adjusted carry assets.
As of the time of writing, the Newfound Multi-Asset Income portfolio is most significantly tilted toward preferreds, mortgage REITs and bank loans, followed by positions in convertible bonds, corporate bonds, emerging market debt and covered calls.

The question implies that volatility is necessarily a threat to investment portfolios and should be reduced. Playing devil’s advocate, there is such a thing as upside volatility—when market prices suddenly spike upward—which is the kind of volatility we want to embrace, not avoid. But assuming we’re focusing on downside volatility—when markets drop dramatically—the magnitude of the expected drawdown would dictate our portfolio positioning.
For large drawdowns—such as full-blown bear markets, where we expect prices to drop by 20% or more—we look to mitigate volatility primarily through our broad asset allocations. In our blended portfolios, that means underweighting stocks, overweighting bonds and maximizing our allowable cash positions to the limits of each portfolio’s investment guidelines.
For our stock and bond allocations, we emphasize high-quality market segments such as U.S. Treasurys, high-quality corporate bonds, currencies, gold and MLPs.
If we anticipate a medium-size correction, such as a 10-20% drawdown, we also want to overweight bonds, with an emphasis on high quality, and we also want to underweight equities. Within our stock-oriented portfolios, we may blend in some precious metals and flight-to-quality currencies such as the dollar, the Swiss franc and the yen, as well as agricultural commodities and utilities stocks.
To buffer against smaller drawdowns—say, between 5 and 10%—our approach is more nuanced. We want to maintain broad exposure to the equities markets but position those exposures towards defensive vehicles. That way, if stocks defy expectations and maintain their strength indefinitely, our portfolios’ risk profile will continue to be broadly aligned with the prevalent market-risk environment, despite their modestly defensive bias.
For instance, in the second half of 2014, we shifted from our typical S&P 500 ETF to a low-volatility S&P 500 ETF. We were concerned a consolidation in the U.S. stock market was coming, but we couldn’t predict the timing. We expected the low-vol vehicle to keep up with the S&P 500 in sideways markets and outperform if a correction occurred. Sure enough, the market started to weaken in September, went through a month of weakness and by late October, we had shifted back to our typical S&P 500 ETF.
In summary, we look to make sure the risk profiles of our portfolios are aligned with the prevalent level of market risk at any point in time.

With the end of quantitative easing in the U.S., we believe the stock market will experience more volatility. That said, we don’t think it makes sense to seek protection through volatility ETFs, which are typically plagued by the “curse of contango.” In other words, when the VIX futures price is higher than spot, there is a pretty steep hurdle rate for investors to make money in these products.
Instead, we’re managing this volatility risk by allocating to stocks outside of the U.S., specifically in Europe and Japan.
In our opinion, these markets will continue to be supported by their central banks, which will boost equity prices. Furthermore, the weakness in both the yen and euro should provide a tail wind to global exporters from these regions.

Olly Ludwig is the former managing editor of etf.com. Previously, he was a financial advisor at Morgan Stanley Smith Barney and an editor at Bloomberg News. Before that, Ludwig was a journalist at the Reuters News Agency in New York.