Tactics to Tame Volatility and Reduce Portfolio Correlation

Modern portfolio theory Is evolving

Traditional, quasi-passive portfolios (allocations of bonds, stock and cash) are becoming increasingly ineffective as traditionally opposed asset classes (e.g., stocks and bonds) move in step in terms of both direction and volatility. This is evidenced by the increased correlation among equity returns, rates and credit spreads on the heels of unprecedented monetary policies enacted by global central banks in response to COVID-19. Many volatility-reducing products have also failed to such an extent that allocators need to consider new tools to reduce portfolio risk.

Products like ETFs, which have worked incredibly well over the last decade, may not solve these issues. The market has become incredibly bifurcated, in that a small number of winners have driven the majority of the returns. Over the last three years, roughly 60% of the S&P 500 returns have come from six stocks. Most ETFs are cap-weighted; as they rebalance, you’re going to be buying much more of what’s gotten more expensive and much less of what’s gotten cheaper. Tactical precision will be rewarded but will be hard to achieve using passive products.

Fixed income investors are especially strained, facing short and intermediate risk-free rates of less than 1.00%; when combined with rising correlations to equities, the value proposition for this space is negligible.

There are opportunities, however, for investors to monetize market volatility while also hedging credit risk to enhance returns and reduce correlation through a tactical approach using alternative, multi-asset strategies. In fact, market events are creating catalysts for renewed opportunity in certain market segments, such as convertibles, which have been overlooked by many investors. Arbitrage opportunities exist as we enter a new credit cycle starting with spreads of 800 to 1,000 basis points over Treasury securities.

A tactical, multi-asset strategy allows a portfolio manager to look across the investment spectrum at preferred stocks, convertible debt, traditional debt, traditional equities, MLPs and ETFs to find the best value opportunities. The inclusion of these often overlooked or misunderstood strategies balances shifting portfolio behaviors and risk — obviously, you’ve got some homework to do first.

Why “alts” Is a four-letter word

After migrating from the hedge fund world, alternatives have found their way into the mainstream. Unfortunately, the myriad of strategies that fall under this classification have been lumped into a catch-all bucket that isn’t always shown in a favorable light. The alternatives moniker is a wrapper for a wide swath of products, good and bad. When it comes to your portfolio needs, it’s crucial to examine strategy-specific goals and if the portfolio manager was able to meet those goals during critical, volatile or high-correlation periods.

Heightened economic uncertainty and volatility (which typically equates to downside risk) requires asset allocators to consider strategies that emphasize loss limitations in bearish or sideways markets. Certain alternative strategies can address the aforementioned issues that investors and advisors are facing.

The multi-asset category has proven to fit this profile and, by design, invests across a broad spectrum of income-producing securities that dampen volatility and provide an asymmetric return profile. Of course, not all multi-asset strategies are created equal. A properly executed multi-asset strategy should be a flexible, tactical approach that varies in composition to mitigate downside losses, while offering true risk diversification and decorrelation compared to other strategies within a portfolio.

One major issue in this category is that half a dozen managers dominate the multi-asset space. Some of those funds have $50, $60 or $70 billion under management. A large-scale tactical shift of 10% to 20% is too big to execute in some markets. If you try to trade $10 or $15 billion in preferreds, convertibles or the REIT market, liquidity becomes a challenge and is likely to move markets adversely.

A market-neutral approach including arbitrage and global convertible bonds offers an attractive opportunity for credit investors who demand low correlation to both equities and traditional credit allocations. This approach offers fixed income investors the ability to generate asymmetric returns in both up and down markets by capturing volatility as a return source. Adjustments in timing and ratios can be made by the manager to finely tune the fund. For allocators facing lower capital market return assumptions as a result of zero or negative risk-free rates, volatility becomes a hedged return source allowing for greater return potential versus traditional fixed credit strategies with a potentially similar risk profile.

The new portfolio: Dynamic with the proper fee construct

Given the macro risks and increased volatility, investors will be best served by deploying opportunistic, tactical strategies that offer asymmetric returns during downturns or in sideways equity markets. Allocations to truly active managers offer increasingly dynamic and constant portfolio characteristics to better capture potential alpha. But whatever product allocation you deem best for your clients’ portfolios, it’s critical that the fee structure complements the strategy and best aligns the interests of the manager with that of the asset owner.

My firm, Westwood, has studied fee symmetry disconnects across many categories. We found average fixed fees in low-risk bond alternatives were severely disconnected from the total return potential of the funds themselves. Investors who pay a high fixed fee will be at a substantial statistical disadvantage relative to traditional bond products. Liquid alternative fees should reflect the enhanced cash rate for beta, the absolute return potential of the strategy, unique manager/product attributes and overall probability of a favorable outcome. The same should hold true across all categories, where beta is typically factored in around the prevailing fee among the cheapest instruments (usually ETFs), from there, a value for realizing excess return potential can be determined.

Harvey Steele joined Westwood in 2018 as head of intermediary distribution. Through his 15+ years in the industry, he has become a successful leader of distribution teams across multiple channels and structures. 

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