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.