Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
What should investors do when confronted with market volatility? The conventional wisdom couldn’t be clearer: Ignore it.
“Often the wisest thing to do during periods of extreme market volatility is to stick with the investment plan that you've already devised,” argued Bill McNabb when he was Vanguard's chairman and CEO. Similarly the Schwab Center for Financial Research commentary on volatility states, “Resist the urge to sell based solely on recent market movements...it’s best to ignore the noise and focus on your long-term goal.” If anything, sudden market lurches downward, such as the 2008 crisis and what we have seen in the past several weeks, could present buying rather than selling opportunities, at least for investors with stable finances, long investment horizons – and fortitude.
The conventional wisdom rests on seemingly strong foundations. It is very difficult, if not impossible, to time the price movements of markets. Also, there is a mean reversion in stock returns, so that a crash today is offset to a reversion to the mean later (i.e. prices rebound); hence the paradigm that long-term investors can ride through volatile periods. Finally, it is important to stay invested in the market. JP Morgan retirement research found that just missing the 10 best days in the market during the 20-year period starting January 1, 1998, would have halved performance. Therefore the convention in financial planning practice today is not to manage volatility – it’s to manage investor worries about volatility.
But what if the conventional wisdom is wrong? In a series of papers published in leading finance journals, the economists Alan Moreira of the University of Rochester and Tyler Muir of UCLA reached a very different conclusion. Their forthcoming paper, in the Journal of Financial Economics, found that when volatility increases, investors “should reduce their equity position.”
The volatility-managed approach
Moreira and Muir’s quantitative framework and detailed empirical analysis pose profound challenges to conventional financial planning practice and to conventional economic theory as well. They find that in response to changes in volatility investors should adjust their portfolio exposures to volatile assets to avoid risk but also to increase returns. In essence, investors still shouldn’t time markets in terms of trying to predict where the market is going – so that part of the conventional wisdom remains – but they should and can time volatility.
Their data shows that when volatility spikes, expected returns increase too in the sense that prices fall. However expected returns do not increase enough to offset this increase in risk. The relationship between risk and reward is broken, which is a puzzle. Hence it makes sense for the investor to reduce their position in the risky asset during volatile times, the opposite of today’s conventional wisdom.
But there are other puzzles too. Volatility, though persistent from period to period, is less persistent than downward changes in price that follow from a financial shock. In another words, the true buying opportunity is not during the feverish period during a crisis but later, when volatility has returned to normal ranges but prices haven’t yet rebounded. Therefore the strategy doesn’t just avoid risk, it can lead to alpha as well.
In their paper, Moreira and Muir constructed portfolios that take advantage of these “puzzles,” decreasing risk when volatility is high and increasing it when volatility is low. They find their strategy produced an annual alpha of 4.9% as well as an improved Sharpe ratio. Importantly, these results held true even though the strategy would not have avoided Black Friday-type events or other surprise selloffs that mark the beginning of a crisis. Additionally Moreira and Muir pointed out their strategy is distinct from and unrelated to risk-parity portfolio techniques. Though the strategy considers transaction costs, it ignores taxes, a potential stumbling block for individual investors.
Practical applications
This new analysis of how investors should respond to changes in volatility is concerned with larger theoretical puzzles of academic finance. For instance, in economic models, volatility and expected returns rise and fall together, otherwise everyone would sell when vol goes up and buy when vol goes down. Why does this risk-return relationship break down in the real world? Another real world puzzle is why don’t more people sell when volatility spikes – is it because they have been told not to?
But the paper also has practical applications of interest to planners in terms of portfolio design. To put some of these new insights to use, advisors don’t have to build Moreira and Muir’s complex portfolios and measures of volatility. They can just use VIX, the CBOE volatility index, as a trigger for monthly rebalancing.
When VIX spikes, in the month that follows advisors can scale back their exposure to the risky asset – equities – and scale up their exposure to the riskless asset – short term Treasury securities. (The technique works for fixed income and other asset classes too. Again investors aren’t completely exiting from the volatile asset class, just dialing up or down their exposure to it). When VIX returns to normal, the advisors increase the exposure to equities and reduce the exposure to the Treasury market. What is key is that advisors make timing adjustments at both ends, knowing when to sell, but also knowing when to buy. In this sense, the strategy isn’t easy because it involves two timing decisions.
Moreira says, “The tricky part is coming back. Selling during a crisis is the easy part, the hard part is enticing clients back afterwards.” If they don’t come back to the market, the strategy doesn’t work. Muir adds, “Vol going back to normal is the signal to re-enter. It is very important for the strategy in our back-testing that you do return once vol subsides.”
Post-crisis financial planning
The financial crisis came as a shock. It revealed many risks ignored or concealed by the certainties of conventional thinking. The U.S. financial sector was much more fragile than anyone believed or even thought possible. Extreme and unprecedented interventions by the Fed helped to eventually stabilize the financial system, but this was reactive and did not head off the growing risks building up before the crisis. And the long-term impact of those interventions is unknown, as is how the Fed might react to a new crisis as well as what form a new crisis might take.
Though our beliefs and understanding of the economy post-crisis has changed, there hasn’t been a commensurate change in financial planning portfolio techniques. Instead of looking more closely at the relationship between risk and reward, the profession too often relies on conventional thinking that often has only worked because of the unconventional moves of the Fed.
This isn’t to say the industry hasn’t made other advances. It has sharpened its thinking about factor exposure and goals-based planning. But some useful innovations remain missing. Individual investors still largely lack access to new, uncorrelated asset classes, many of them illiquid, and sometimes lower in volatility as well.
The new research about volatility by Moreira and Muir represents a needed “shock” to post-crisis financial planning. It introduces ideas about portfolio design known but also hotly debated among theorists that haven’t yet been widely applied.
This does not mean advisors should accept these findings without question or challenge – quite the opposite. Can these findings be replicated? How should they best be applied in terms of scaling up or down volatile assets? What happens to returns if everybody sells in response to volatility? What is the impact of taxes? Will these findings work going forward?
The answers to those questions are still largely unknown. But advisors can begin debating this new approach, accepting some findings, rejecting others, seeing for themselves what works and what doesn’t in practice. They may find there are better responses to a spike in volatility than just riding through the storm. Let the debate begin.
David Adler previously wrote about liquidity premiums for Advisor Perspectives. He is author of the monograph, “the New Economics of Liquidity and Financial Frictions,” published by the CFA Institute Research Foundation. He is a senior advisor to XA Investments, a Chicago investment manager that provides access to illiquid alternative investments using closed-end funds. The views expressed here are his own and don’t necessarily reflect those of XA. He can be reached at [email protected]
Read more articles by David Adler
