Round 2: winning the mental battle against volatility using….volatility.

Last post addressed one way to deal with the mental anguish provided by market volatility: the ostrich method.  It’s a simple method, albeit not particularly sophisticated.  Also, the ostrich method doesn’t really help improve portfolio performance, aside from keeping the investor away from rash trading decisions.

So let’s try another way; let’s consider using market volatility as a weapon of choice against market volatility.  Let’s see how more volatility can help our portfolio weather the markets.

To conquer volatility, you must become...oh never mind.  Source: Google Images.

To conquer volatility, you must become…oh never mind. Source: Google Images.

Again, let’s focus on a concrete example:

And the data, with monthly views.  I’ve included a 100% equity portfolio for comparison:

Cutting volatility through diversification.  Source: Quandl.

Cutting volatility through diversification. Source: Quandl.

A couple observations:

  1. Wow, what a run from stocks since 2008
  2. Even with 60/40 portfolio balance, the portfolio looks a lot like the 100% equity portfolio.  How much diversification am I really getting?

OK, so we can show that diversification generally works to lower portfolio volatility (from about 16% p.a. with all stocks, to about 10% p.a. with 60/40 blend).  Returns are a bit lower, but risk-adjusted return is a bit higher.  What I’m not so happy with is the following:

  1. My portfolio still looks very equity-like, even with 60/40
  2. This diversification is expensive: I’m sacrificing about 1.2% returns p.a. for the peace of mind coming with diversification

How to solve this?  Here’s one idea: suppose I created a new portfolio holding called Triple 5-year Note.  This holding is exactly the same as the 5-year note in the example, but has 3 times the return stream.  That means 3x the risk and 3x the return.  For those familiar with futures markets, this is absolutely trivial to create (provided account size is large enough to overcome lot size issues, but I digress).

Let’s now add a 3rd portfolio to the arsenal, which is 60% stocks and 40% Triple 5-year Note:

More vol = better portfolio.  Source: Quandl.

More vol = better portfolio. Source: Quandl.

A few observations:

  1. The new portfolio is a bit less equity-like.  In particular, I note smoother performance around the tech bubble, and better performance around 2008
  2. Diversification is cheaper.  I only sacrificed 0.8% returns p.a. for my diversification
  3. The new portfolio looks less volatile than the others.  And it is: portfolio volatility is 9%, rather than 10% or 16% in the older case

So what have we done?  We’ve lowered portfolio volatility and increased returns over the old 60/40 by increasing volatility of the diversifying asset.  The 5-year note future’s volatility is about 5% p.a., which is roughly 1/3 equity volatility.  By increasing the 5-year volatility to equal that of equities, we get more diversification.  That leads to better portfolio returns, and lower portfolio risk.

Extension: some may recognise this idea as a basic concept behind products such as Risk Parity or Managed Futures strategies.  In a nutshell, the strategies equalise each asset’s volatility in the portfolio, then weight each (volatility-scaled) asset such that diversification is maximised.

How to implement: I can think of a few ways to fight portfolio volatility through this method:

  1. Use futures/options – if your account is large enough (e.g. 1 E-mini S&P Future has a notional value of around $100,000, and 1 5-year note future has a notional value of about $120,000), use futures as a replacement for long stocks/bonds.  You can easily create the Triple 5-year through buying 3x the note futures.  Smaller accounts can use option strategies, such as buying deep ITM calls or vertical spreads.  NB: you’ll need to roll these derivatives each month to maintain exposure.
  2. Use leveraged ETFs – for example, TYD is a 3x-levered ETF on 7-10 year US Treasuries.  It’s very illiquid, so be careful.  Vol drag might be an issue, but probably not very (volatility is low, and carry is positive).
  3. Buy a mutual fund – for example, AQR has a well-known Risk Parity mutual fund which uses similar techniques as noted above.  It would mean having only this fund in the portfolio, rather than in addition to other holdings.  But it’s an easy solution.

Next time, I’ll talk about managing portfolio volatility through adding managed futures.  In particular, what adding a small allocation to the strategy, and the effect of lower/higher volatility programmes, do for portfolio performance.

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4 thoughts on “Round 2: winning the mental battle against volatility using….volatility.

  1. To the methods Matt I would add:

    a) Accepting you are going to get lower risk and returns, which means something like a 75% bond and 25% equity portfolio to get the vol to match.

    b) Buying longer duration bonds, or bond funds. I think a 30 year bond should have close to equity like risk. Admittedly the Sharpe ratio of these guys hasn’t typically been as good as the 5 year bond, which tends to offer the best carry.

    c) Buying higher yielding corporate bonds. This will make your bonds more equity like, and reduce the diversification effect of course.

    d) Buying high yield emerging market government bonds.

    e) Using a margin account to buy bond ETF’s or similar – creating your own leverage. This is slightly worse than futures since you’re paying a premium on the funding charge, but at least in the US I think the interest is tax deductible and you get more choice.

    Disclosure: As well as the futures route, I’m using c, d and e.

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