Last year's collapse of a bridge in Minneapolis was blamed on design flaws, the National Transportation Safety Board advises. Alas, there is no federal agency that dissects failure in investment strategies, although design flaws are surely a basic catalyst here as well. That begs the question: What's behind design flaws? Misjudging risk, of course. What's true for bridges also applies in portfolio management.
Yes, risk has a thousand faces in the money game, causing trouble for securities, asset classes and investment portfolios alike. But risk also has a common feature in finance: volatility. It's not the only measure of risk, although history reminds that higher volatility is almost always associated with elevated risk. It's not a perfect relationship, but it's far too common to dismiss.
The latest round of empirical evidence needs no introduction. Volatility has recently spiked higher almost everywhere you look in the capital and commodity markets. U.S. equities, for example, posted a volatility surge of epic proportions in recent months. October 2008 will likely stand as the high water mark for some time in S&P 500 volatility. The benchmark's standard deviation soared to 6.9% last month, based on intra-day data for the index, reports Aronson + Johnson + Ortiz, a quantitative money manager in Philadelphia. That's far above the daily average of 1.5% since 1962 and comfortably above the second-highest spike during the past 46 years: October 1987's 5.1%.
"Typically, a period of high volatility coincides with market bottoms," says Stuart Kaye, a principal at AJO. But not always. The stock market's trough in August 1982 didn't accompany a volatility peak, he notes. That's the exception, though, or so history suggests.
The skyward jump in risk is even more dramatic when measured by the VIX, a widely watched (and traded) measure of S&P 500's implied volatility based on options. For a time last month, the VIX traded at just under 90--an all-time high. Previously, the index rarely climbed above 30 and only once has it moved above 50 since 1990.
All of which reminds that using volatility and its statistical cousins as risk proxies has merit. No, volatility shouldn't be used in isolation. On the other hand, ignoring it isn't all that shrewd either. There are no silver bullets here. The next best thing is a broad and ongoing review of risk, of which volatility is a key component.
Consider one VIX-based application that measures cyclical risk exposure for portfolios and their components. To the extent that the VIX index rises when markets fall, the relationship offers clues about a portfolio's overall sensitivity to bear markets generally.
If an asset's price tends to fall during periods of substantially higher volatility, the asset has a "short volatility" profile. "Most forms of risk premium or beta, and all of those connected with equity, credit and real estate markets, public as well as private, have short volatility characteristics," writes Paul Goldwhite, director of research at First Quadrant, a quantitative institutional money manager in Pasadena, California. By contrast, long volatility asset classes (i.e., investments that do well when markets tumble) are a rare breed, he explains in a recent research brief published on the firm's web site.
Statistical support can be found in the correlations of the VIX and asset classes. Most asset classes, and a surprising number of hedge fund strategies, have short-volatility tilts, Goldwhite finds. As a result, true diversification choices are few and far between, even among hedge funds.
For instance, U.S. stocks, foreign stocks, high-yield bonds, real estate and quite a few hedge fund strategies (including equity market neutral) harbored short volatility characteristics in the 10 years through last September. That suggests that these asset classes and strategies are vulnerable when volatility runs skyward. As a result, there may be less diversification in these corners than is generally recognized.
Recent market trends only emphasize the point. All the major asset classes are suffering from varying degrees of red ink this year through the end of October. Meanwhile, all hedge fund strategies save the short-bias category are suffering too, according to www.barclayhedge.com .
Bucking the trend with so-called long volatility betas and strategies may be hard to find, but it's not completely absent. Short strategies are one example. Meanwhile, managed futures mandates have done well this year too. And bonds also exhibit some mild strains of long volatility over time--the Lehman Brothers Aggregate Bond Index, for instance, according to First Quadrant.
There's also the realm of alpha, which is to say something other than beta. Goldwhite's research counsels that "pure alpha strategies by definition have low correlations to equity and credit markets and other risk premia. They should also have low correlations to changes in volatility, and these strategies are valued for their defensiveness in volatile market environments," he writes.
But the alpha solution isn't a free lunch. Identifying investment skill--the sine qua non for minting alpha--is tough, if not impossible. True talent, after all, is scarce. And even if alpha can be consistently recognized in advance, over time, not all alphas offer comparable degrees of diversification for conventional portfolios. Indeed, some may simply be high-priced betas dressed up as alpha. Even worse, such shortcomings tend to become obvious only at inopportune moments--like the last two months.
Successful risk management may not be so easy after all--in bridge building or portfolio management.
James Picerno is senior editor of Wealth Manager.