Accretive On: Volatility Targeting Strategies

May 13, 2019

In the last two weeks investors have experienced increased volatility, an uncomfortable but normal and healthy feature of markets.  Volatility reminds investors that markets are risky and helps keep animal spirits in check. Over the last decade or so, we’ve seen an increase in investment strategies built around targeting a certain level of volatility in portfolios.  This has the effect of dampening volatility further while it is declining and exasperating it while it is increasing.

Here are the basic mechanics of how it works.  A strategy will target a given level or band of volatility, say 10% or 10-12%.  The strategies we are talking about will get signals indicating volatility is too high and to reduce the most volatile holdings (stocks) in the portfolio so volatility is in the target range.  This activity itself impacts the market, generating even greater volatility and more sell signals for the strategy.

There’s an old saying in markets that stocks take the escalator up and the elevator down.  Put another way, as stocks fall they tend to do so faster than they rise, increasing volatility.  In this example the reason doesn’t matter, but let’s say for the sake of argument it is a “trade war”.  The market reacts negatively, sending stocks lower and volatility higher, generating the initial signal to reduce equities in order to get the volatility down.  

The Wall Street Journal highlighted this over the weekend.   The article highlights the amount of assets tied to these types of strategies, which are reported to be about $400b.  I found the wide range of equity exposures in such a short period of time quite surprising,from being over 80% invested in stocks at year end 2017, to being about 20% invested about 6 short weeks into 2018.  As the volatility washed out and markets recovered, these strategies systematically and gradually increased exposure to equities into the mid 60% range by October, right before the year end sell off. By Boxing Day (the day after the recent market low), these strategies were only 16% invested in equities.

After reading this article, I have a few takeaways:  

The first is that these strategies help create a feedback loop of increasing and decreasing volatility, put another way, they help create self-fulfilling prophesies.  The second is that these strategies come with a clear cost to investors, this is in addition to the costs of executing on this type of strategy, and that is systematically being over or under invested at the worst or best possible times.    

You may be wondering what relevance any of this has to a long-term portfolio.  The answer is not a whole lot but being aware of what’s going on can help investors avoid following a similar strategy in a less systematic way.  It can also serve us if we are looking to put money to work or make a long term strategic allocation.  

At Accretive we take a different approach.  We try to understand the holdings in our portfolios and how we expect them to behave in various market environments,contemplating both good and bad ones. Our default stance, absent changes to the economy, is that we’re inclined to stay the course and possibly look for ways to put money to work.

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