The fact that correlations converged amid the market declines of 2008 called attention to the limits of relying on diversification between assets for portfolio protection.   It’s not that portfolio managers did not attempt to manage the risk. The desire for non-correlated returns among assets had already led to a significant reduction in U.S. equity exposures and accelerated flows into non-U.S. equities and alternative strategies.  But the correlations of these supposedly uncorrelated assets unexpectedly spiked under the extreme market stress of 2007 and 2008. This shows that for downside protection, buying assets with many different risk profiles is not a substitute for buying volatility to manage risk. 

The table below compares the correlation of a number of asset classes to the S&P 500 for two periods:  The up market period during the last decade and the bear market period from Oct. 2007 to Feb. 2009.  During the bear market period when the benefits of diversification were needed most, correlations skyrocketed across the asset spectrum.  The notable exception was volatility which decreased by 122%. 

Correlations Change Over Time

	Up Market Periods 1/1/2000 to 12/31/2010	Down Market Period 10/1/2007 to 2/28/2009	% Change
S&P 500	1.00	1.00	N/A
Russell 1000 Value	0.86	0.98	14%
Russell 2000	0.43	0.96	123%
MSCI EAFE	0.63	0.91	44%
MSCI World Ex-US	0.65	0.91	40%
MSCI Emerging Markets	0.47	0.80	70%
DJ Credit Suisse Hedge Fund	0.09	0.58	544%
S&P GS Commodity Index	0.08	0.56	600%
NAREIT U.S. Real Estate	0.25	0.83	232%
BC U.S. Corporate High Yield	0.31	0.71	129%
BC U.S. Agg Bond TR USD	0.00	0.36	3600%
CBOE Market Volatility	-0.32	-0.71	-122%
Source: Clark Capital Research, Morningstar Direct

Worries over potential government defaults in Europe and a sluggish economic recovery in the U.S. have dampened some of the enthusiasm generated by the market rally of 2009-10. Advisors are now conditioned to expect that adding equity of any kind to a portfolio may feel like entering a mine field. This is where low volatility equity strategies may serve as an addition or replacement for the equity core in a portfolio.

Low volatility equity strategies have attracted attention from institutional investors in recent years. Investors showing interest in these strategies often ask the same questions: “Is now the best time to invest? Since these strategies seek attractive downside protection in falling markets, did I miss the opportunity by not investing prior to the start of the bear market in late 2007?” These questions are difficult to answer correctly without perfect foresight. However, an understanding of how low volatility equity strategies are expected to perform over time, along with a review of today’s market environment as it relates to recent history, may help an investor answer these questions with greater confidence.

The objective of low volatility equity strategies is to deliver returns that are similar to those of equity indices (“the market”) over a market cycle but, as the name implies, with less volatility of returns. Most traditional equity strategies incorporate many benchmark-relative risk management constraints such as size, style or beta.  Breaking from how most traditional equity strategies are managed, Clark Capital allocates to volatility as an asset class by incorporating  S&P 500 Index put options in an opportunistic equity allocation.  History shows that volatility wreaks havoc on investors’ psyches (not to mention their portfolios) as proven by Dalbar Studies¹ year in and year out. Clark Capital embraces volatility as an asset class as a means to consistent non-correlation.  Our strategy seeks to provide structured risk management while being fully allocated to equities.  

This is not simply asset allocation between types of securities, i.e., “a balanced strategy,” or a market-timing strategy that cycles in and out of cash but rather a risk-managed approach designed to maintain an acceptable risk profile throughout the market cycle.   The primary goal of our hedge strategy is to contain equity risk without giving away equity opportunity.  Below is a table that illustrates the quantitative value of adding a 5% allocation to volatility (the VIX Index) to a diversified equity portfolio.²

As of 3/31/2011	Asset Allocation	Asset Allocation with 5% Volatility
1 Year Return	15.61	14.2
3 Year Return	4.16	4.55
5 Year Return	5.27	6.36
10 Year Return	5.49	5.76

1 Year Standard Deviation	11.42	8.37
3 Year Standard Deviation	14.91	11.28
5 Year Standard Deviation	12.13	9.18
10 Year Standard Deviation	10.54	8.14

1 Year Beta	0.61	0.42
3 Year Beta	0.67	0.49
5 Year Beta	0.67	0.47
10 Year Beta	0.62	0.45

We have always believed that risk control is the key to wealth creation.  It allows an investor to remain invested throughout a market cycle and thus not miss out on the inevitable market rebound.   How many investors missed most if not all of the 95% gain in the S&P 500 from the low of March 9, 2009 through March 9th of this year?³  If money flows are any indication, consider this: from the beginning of 2008 through the end of 2010, mutual fund investors pulled more than $272 billion from U.S. stock funds and poured almost $650 billion into bond funds, according to ICI⁴.  Research shows that most of this activity is directed by retail investors.  More recently, money flows have turned convincingly positive in the first quarter of 2011. As the persistent advance over the last two years has begun to sink into investors’ psyches, net inflows into both domestic and foreign equities were recorded at $30 billion.⁴   This was the first positive quarter of net inflow into equities in over two years.    

The primary tool individual investors utilize to manage equity volatility is fixed income.  Fixed income has had a spectacular run as yields have been dropping since 1981.   Presently fixed income yields are near record lows for the last 50 years.   Conventional wisdom based upon where we are in the economic cycle, the inflationary pressures of rising prices in commodities, and the level of public and private debt leads most people to think the bull market for bonds is coming to an end. In the short run we expect rates to be range bound but in the long term we are more likely to see the fixed income markets perform similar to their action in the period from May 1954 to August 1981.  During this period equities performed reasonably well but fixed income actually had a negative return after adjusting for inflation. This change, we posit, calls for investors to broaden their tool set and examine alternative ways to manage equity volatility. 

Source: Federal Reserve Bank of St. Louis, Morningstar Direct

Returns reflect reinvestment of capital gains and dividends, if any. Indices are unmanaged and do not incur fees. It is not possible to invest in an index. Stocks are represented by the S&P 500 Index. Bonds are represented by the Ibbotson Associates U.S. Long Term Government Index. Inflation-adjusted returns are based on the average Consumer Price Index (CPI) through the referenced period (5% from 1954 to 1981 and 3% from 1981 to 2009).

Low volatility equity strategies have appeal within a diversified equity allocation, as they seek to reduce equity drawdown and volatility of returns, thus offering an improved profile of expected return per unit of total risk relative to a standard equity index.  Secondly, the low risk profile allows a larger allocation to equities.  These compelling aspects of the strategy are felt over the long term, as compounding effects benefit the strategy through oscillating markets. For advisors seriously considering an allocation to these strategies, identifying the right time to invest is important. While the inability to successfully predict the future makes this part of the process imperfect, understanding the environments when low volatility strategies are expected to be most attractive can help support the decision that the time to invest is now.

So, is allocating to a low volatility equity strategy a wise move today?  Investor psychology would indicate that an allocation to a low volatility equity strategy should be made after volatility (as measured by the VIX Index) has reached a relative peak and the market has reached a relative bottom. However, in reality, a more attractive entry point may be after the VIX has bottomed and the market has just risen rapidly from a low point. Allocating to a low volatility equity strategy, therefore, may be more attractive today than it was a year ago. As we look to 2011 and beyond, we believe equity market volatility will continue and correlations between equity asset classes will remain high. At the same time, we believe that the equity markets continue to be the best place for long-term investors. Some investors might view this as an uncomfortable, unwinnable contradiction, but we do not. We believe a core allocation to a low-volatility equity strategy provides a risk-managed means to pursue market opportunity in the face of continued volatility.

ABOUT CLARK CAPITAL

Clark Capital Management Group, Inc. focuses on providing low volatility investment solutions. Our investment philosophy is based on two fundamental beliefs.  The collective wisdom of the market is consistently more accurate than any one investment strategy.  The daily action of market participants creates inertia, revealing a directional ebb and flow, which is translated through price.  The essence of our research measures the “relative strength” of this movement in price which allows us to adapt to changing themes and is not biased to a traditional style or market capitalization approach. Volatility can be managed as an asset class in an attempt to defuse correlation spikes across other asset classes.  When “relative strength” and “managed volatility,” are used in tandem, investors may be able to participate in asset class leadership and long-term global themes while benefiting from a non-correlated asset, which assists in risk management and capital preservation.  

Founded in 1986, Clark Capital Management Group, Inc. is an independent employee owned investment advisory firm, managing over $2.46 billion⁵ in client assets and based in Philadelphia, PA.  Clark Capital is focused on both long only and innovative risk management strategies, with a goal of successful capital preservation. Clark Capital tailors its Navigator® Investment Solutions to the unique requirements of high net worth individuals, corporations, trusts, endowments, foundations, and retirement plans.

 

 

(c) Clark Capital Management Group

www.ccmg.com