For the top-down, market-timing approach to volatility management, the drivers of returns will be at the asset class level, and the keys to success is being in the right place at the right time. Certainly if one has the wherewithal to 1) successfully forecast major market sell-offs and avoid them and 2) predict when markets are about to take off and capitalize on rallies, then their performance results would look fantastic.
As discussed previously, when it comes to factor analysis, no factor works all the time. The best a factor-based approach can reasonably hope for is to be right more often than it is wrong. The bigger risk, however, is that most factor analysis does nothing to address the biggest “factor” of all—market risk. A fully invested portfolio that tilts toward low volatility, or any other factor, is unlikely to avoid significant losses should the markets sell off by 30%, 40%, 50% or more. This topic is explored in our blog post on smart beta strategies and systematic risk.
For those low volatility strategies that employ a top-down, market timing approach, the risks are different. As stated before, the key to success with the market is being in the right place at the right time. The risks, however, are being in the wrong place at the wrong time. If one “misses the boat” with their tactical asset allocation decisions, either absolute or relative performance can suffer greatly. Market-timing is explored in depth in this blog post, but can be summarized with the old catchphrase, “Live by the sword, die by the sword.”
Role in a Portfolio
If either a bottom-up, factor-driven or top-down, market timing low volatility strategy is able to successfully generate lower overall volatility, then it would likely benefit an overall portfolio. In a previous blog, we discussed the detrimental impact volatility drag or variance drain can have on an investment’s return. Low volatility is certainly a desirable trait in an investment. In fact, the DRS also has “low volatility” as a goal for its portfolio, but we seek to accomplish low volatility in a different fashion.
Low Volatility Strategies vs. Defined Risk Strategy
Where the DRS differs from “low volatility” or “managed volatility” strategies are in philosophy and approach. Swan believes that the biggest risk that any investor faces is market and systematic risk. During the big, bear market sell-offs, almost everything tends to go down at the same time. A factor-based, bottom-up, low volatility strategy might outperform the S&P 500 on a relative basis, but it will likely still lose a significant amount in absolute terms. With respect to market-timing, Swan has always been skeptical. Swan believes it is too difficult to consistently call the tops and bottoms of markets and reposition the portfolio accordingly.
It is these two core beliefs—the concern regarding market risk and a lack of faith in market-timing—that underpin our “always invested, always hedged” philosophy. Unlike the top-down, market-timing strategies, we remain “always invested” with our buy-and-hold positions in market ETFs. While bottom-up, volatility-factor analysis fails to address systematic risk, we seek to do so and remain “always hedged” by protecting the portfolio via long-term put options. Using this time-tested strategy, we believe we have a better way of producing low volatility results.