Managing portfolio amid current volatility

ANUBHAV Shrivastava Partner, Infinity Alternatives

Financial markets have seen wild swings in the last few weeks – both equity and debt markets spiked and tanked simultaneously adding a level of risk to portfolios that are no longer hedged. In simpler terms, movement in equities has started to correlate with the liquid government securities (G-Sec) market.

Additionally, the global geopolitical and trade news hasn’t been positive either. The US-China Trade war continues, oil supplies were disrupted, which in turn caused some pressure on the rupee, and major global economies looking at a race to the bottom as far as interest rates are concerned. Naturally, this has raised concerns among investors as to where is all this headed. How serious is the slowdown and what is it that they can do to ride this volatility?

Volatility is a commonly used term to represent movements in the price of individual securities or the index.

At the market level, this measure is generally represented by the ‘VIX’ or the volatility Index and a higher number represents a more volatile market which is less predictable – sharing an inverse relation.

Investment behaviours: As is often the case, the investors tend to be more risk-tolerant in bull markets and when markets are benign and can get risk-averse as market conditions change. The problem surfaces when running a buy and hold long strategy is coupled with emotional buying in spiking markets and sell-offs in tanking markets – buying high and selling low can erode a significant amount of returns.

Asset Allocation Portfolio: There are two ways of dealing with such inclement market conditions – one is to set up an allocated portfolio which assumes that, over longer period, there is a certain constant level of risk in different asset classes. A classic example is a 60:40 of the Equity: Debt portfolio. As the two movements, the portfolio is rebalanced to book profits, buy low/sell high and it generally ignores shorter-term volatility movements. The same concept can be used to extend the number of asset classes to commodities, International Bonds and equities, energy among many others to diversify the portfolio,

Volatility Targeting Portfolio: The other, more active management is to target volatility. At the onset, there is a determination of what level of volatility is appropriate and acceptable for an investor, at the portfolio level. Constituent weights (different asset classes in the portfolio with respective proportions) are then adjusted to arrive at the asset allocation. Over time, as an implied risk in the markets, and thereby volatility moves, the portfolio is adjusted, and the stocks and bonds are bought and sold to maintain a constant level of risk.

Generally, in our initial 60:40 portfolio, in times of high equity market volatility, there will be a move towards a lower level of equity holding as stock market volatility rises and conversely, a higher amount in stable markets.

These portfolio management techniques lower risk by limiting a portfolio’s downside exposure while still capturing growth on the upside.

So, what are the pros and cons?

Costs: Portfolios that target short-term volatility, may have a higher churn and consequently higher transaction costs or even taxes depending on the type of structure it’s managed in.  For short term spikes in volatility, a portfolio with a strategic allocation is less likely to upend a desirable allocation – a lower risk portfolio will have less aggressive equity allocations.

A volatility targeting portfolio may end up with short-term allocations that are counter-intuitive to an investor’s risk appetite, however fleeting.

In conclusion, both strategic and volatility targeting strategies will need a high level of financial and statistical knowledge and should ideally be done with the assistance of qualified and experienced managers. 

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