Editor's note - David Skordal, Partner/Portfolio Manager, ABR Dynamic Funds, LLC, is the author of this blog
The dips in August 2015 and January 2016 have served as reminders that the U.S. equity markets are now in the eighth year of a bull run, and equity crises happen on a regular basis. In the last 30 years, there was Black Monday, the Savings & Loan Crisis, the Russian Financial Crisis, the Tech Bubble Collapse, the Credit Crisis, the Flash Crash, and the Greek Crisis, just to name a few. Based on the Shiller P/E Ratio and the real bond yield (nominal yield minus inflation), stocks and bonds are more expensive than they have been at least 90% of the time over the last century. As a result, the typical 60% stocks and 40% bonds portfolio appears poised to disappoint investors whenever the next crisis does strike (and perhaps in the interim). Savvy investors should be diversifying out of “60/40” and into other asset classes.
Shiller P/E Ratio:
Nominal U.S. Treasury yields:
There is one asset class, in particular, that is well-suited to complement equities in a crisis: volatility. Volatility assets can be very useful in a portfolio because they tend to spike precisely when equities tumble (“Smart VolatilityTM: Dynamic Management of Volatility as an Asset Class,” pages 1-3). Unfortunately, over the long-term, they create a drag on a portfolio (“Smart VolatilityTM,” page 3). The tendency to spike in an equity crisis and the long-term decay are the two main characteristics of volatility instruments. Combined, they ensure that a static allocation to this asset class is problematic: a static long volatility allocation can cause an investor to “bleed out” from the decay, and a static short volatility allocation can cause an investor to “blow out” from the spike.
The solution may be Smart VolatilityTM. Smart Volatility is the dynamic management of volatility as an asset class. It rebalances into varying static volatility holdings depending on market conditions. The rebalances are intended to capture the spikes and avoid the decay. Therefore, Smart Volatility may unlock the significant potential of volatility assets in a crisis while mitigating their costs in the long-run.
However, “armchair” dynamic rebalancing is not prudent, even for an experienced investor who is willing to sit in front of stock monitors and pick spots for rebalances. Aside from the considerable time and effort that must be invested, the problem with this approach is that volatility assets do not behave according to most people’s intuition or training. For example, “buy and hold,” “buy low and sell high,” and “buy the dips” are just a few of the missteps people make when they manage volatility like any other asset class (“Smart VolatilityTM,” pages 4-6). Instead, because volatility behavior runs so contrary to intuition, it may be better to manage volatility assets systematically, without manual intervention, according to carefully tested quantitative principles of volatility behavior (“Smart VolatilityTM,” pages 7-8).
Some of the best Smart VolatilityTM indices include multiple holdings. For example, a Smart Volatility index could primarily utilize equity holdings during a bull market, which experiences rallying stocks and decaying volatility assets. It could then rotate into volatility holdings in a crisis, which experiences spiking volatility assets and tumbling equity assets. In this manner, the use of multiple holdings may allow Smart Volatility indices to perform favorably in various market conditions.
Click here to download the full paper Smart VolatilityTM: Dynamic Management of Volatility as an Asset Class
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