Risk taking has recently paid for investment managers.  In general, high volatility managers have benefited from two consecutive years of double digit stock market gains.  Portfolios with greater concentrations in small and emerging market companies have outpaced peers.  The result is that the more aggressive set of managers are regaining visibility with investors, especially as 2008’s bear market begins to roll off the trailing three-year performance.

As the annual Dalbar study reminds us, investors, if left to their own devices, tend to succumb to their natural emotions of fear and greed causing damage to their portfolios. The trap of the high volatility manager is that the market cycle appears even more severe, attracting investors to buy at the top and then abandon the product at or near its market lows.  This is all too familiar territory for advisors, as is the need temper expectations for the “big score.”

In light of these issues, we would like to share our thoughts on how advisors can use and become better acquainted with high volatility managers. 

The types of strategies that have big swings in return from quarter-to-quarter are usually very style specific. That is, there is something about the manager’s investment philosophy or process that allows the portfolio to dramatically outperform the benchmark, but only under certain market conditions. It might be trend following strategies (i.e. momentum growth) or conversely, one that invests in companies emerging from bankruptcy.  Other examples include: concentrated aggressive growth portfolios; leveraged equity or bond portfolios; and certain sector biased or themed strategies.

Whatever form the product takes, the home run potential can be used to add alpha to an overall adequately diversified portfolio. This type of product should be used in limited allocations in conjunction with a sound understanding of the manager’s philosophy and process, and the type of market environment that will generally result in outsized gains.

One of the keys for setting proper performance expectations is to understand the risk management process (or lack thereof). Start by asking for the portfolio manager’s definition risk because it may be materially different from you or your client.  Is it volatility, loss of principal, down side deviation?  Is it relative to a benchmark?  Next, try to examine how risk is managed in different scenarios, particularly during turbulent markets. Does the team adhere strictly to pre-set absolute guidelines? Or is it less specific, based on the subjective judgment and experience of the manager? 

If you are evaluating a manager that has had eye-popping returns in a short period of time, inquire about how they achieved those results. Then you can gain a better feel for the risks a manager is willing to take and the types of market conditions in which the product will excel.  It is likely that they had to take on significant risks to hit that home run and beware claims of repeatability.

A high volatility product should not be considered an “all-season” product.  They are designed to be a small part of an investor’s overall asset allocation strategy. Quarterly reviews of asset class and manager allocations and performance, along with range-based rebalancing can help advisors keep the returns and risk statistics of the integrated portfolio at the suitable targets for the client. 

The best way for an advisor to add measurable value to their client situations is to help them make difficult buy and sell decisions and impose the discipline that they may lack due to the emotional nature of investing.   Advisors who can correctly manage client expectations, structure well diversified portfolios, and keep the exposure to this type of product limited, can actually add value through both increased returns and improved diversification.