I just returned home from the 20th Annual Global Indexing & ETFs Conference in Scottsdale, Arizona. Popular topics included moving beyond cap-weighted index funds, the growing search for yield and the increasing role of volatility in the management of risk.
The conference organizers had asked me to participate on the volatility panel and the moderator kicked off our panel’s discussion by asking, “What do we really mean by volatility?” The easy answer might include addressing the craziness, or lack thereof, in fluctuating asset prices. A more sophisticated response might differentiate between historical price movement and the risk of loss. For example, if Exxon Mobil (XOM) drops from a $102 per share down to $74 per share because there are extreme price shifts in an underlying commodity in its business pipeline (i.e., oil), has the dividend aristocrat that pays 3% become more risky? Exxon Mobil’s stock price, like oil itself, may become more volatile for a brief period, yet scooping up shares of XOM at $74 might actually be less of a risk than when it had traded north of a $100 per share.
Intrigue in oil price volatility notwithstanding, I felt the attendees would be better served to hear my perspective on what transpires in the real world; that is, Pacific Park Financial clients do not care to make the distinction between good volatility and bad volatility — they just want me to respond to “black swans,” “left tails,” or stock market Armageddon in a way that preserves the bulk of their portfolio dollars. After all, for regular folks, volatility and risk are one in the same.
Should we blame them? In 2000 and again in 2007, scores of endlessly bullish gurus misled their followers by touting volatility as opportunity. Take author James Glassman who wrote the bestselling Dow 36,000 at the height of 2000 euphoria. Few books have ever been less prophetic and more harmful. The same Mr. Glassman boasted about American International Group (AIG) in June of 2008 because the stock was down 30% and had a P/E of 6. Had you bought AIG on his guidance, you would have lost all of your investment in the company. And these are the people who love to tell you about “good volatility.”
In contrast, most people would rather see their portfolios fluctuate less. Need proof? Today, nearly $15 billion with a “B” rest within the coffers of “Low Volatility” ETFs. In contrast, “High Beta” or “High Volatility ” ETFs have struggled to capture the imagination of investors, bringing in a modest $250 million. Rightly or wrongly, it is clear what the public thinks about stocks with greater price fluctuations. It is part of the reason that iShares USA Minimum Volatility (USMV) is featured prominently in my client accounts.
At the same time, funds like USMV should not supplant dynamic asset allocation pursuits. When stocks fall hard – when a bear finally arrives – I could hardly run a victory lap if a client has lost 35% when the market loses 40%. I have been hired in large part to reduce risk in bearish environments, raising cash in volatile downturns as well as shifting assets to safer havens. And while it is true that losing 15%-18% in this hypothetical scenario might not win me any awards, it will help my clients achieve their long-term goals; after all, one requires 25% to recover from a 20% draw-down, while one requires nearly 67% to recover from a 40% thrashing.
So what types of assets might I gravitate towards when stop-limit loss orders execute or when significant stock benchmarks breach respective trendlines? Over the last 25 years, I have found that certain assets and certain asset types minimize the volatility of stock ownership by their mere inclusion in a total portfolio. U.S. sovereign debt is typically beneficial (e.g., zero coupon, inflation-protected, long-dated Treasuries, municipal bonds, etc.). Well-regarded currencies from the dollar to the Swiss franc have been effective. The sovereign debt from influential economies like Japan and Germany also work. Commodities like gold have also served to offset stock scares.