Why riding out turbulence may not always be the best way

Why riding out turbulence may not always be the best way

Why riding out turbulence may not always be the best way

In times of volatility, conventional financial-planning wisdom holds that it’s best to avoid selling risky assets. Since it’s difficult to time downward lurches, investors are often better off counting on upward mean-reversion as well as outsized returns during the markets’ best days to overshadow their losses.

But in a series of papers, economists Alan Moreira of the University of Rochester and Tyler Muir of UCLA challenge that wisdom. Their conclusion, highlighted in a forthcoming paper in the Journal of Financial Economics, is that investors “should reduce their equity position” when volatility increases.

“They find that investors should adjust their portfolio exposures to volatile assets to avoid risk but also to increase returns,” said David Adler, senior advisor to Chicago-based investment manager XA Investments, in a column featured on Advisor Perspectives.

Based on their own quantitative framework and empirical analysis, Moreira and Muir found that while volatility-driven price drops do create higher return expectations, those higher expected returns aren’t enough to offset the increased risk. In addition, downward changes in price following a financial shock tend are more persistent than the volatility observed around that period.

Together, the observations suggest that there’s a true buying opportunity to help investors avoid risk and increase alpha: the period immediately after a crisis, when volatility returns to normal ranges and prices are still at bargain levels.

The two economists constructed portfolios that exploit the phenomena they observed, decreasing risk during times of high volatility and raising it in low-volatility periods. The result: an annual alpha of 4.9% as well as an improved Sharpe ratio, even though the strategy would not have avoided Black Friday-type events or other surprise selloffs.

“To put some of these new insights to use, advisors don’t have to build Moreira and Muir’s complex portfolios and measures of volatility,” Adler said. “They can just use VIX, the CBOE volatility index, as a trigger for monthly rebalancing.”

When the VIX spikes, he explained, advisors can wait for the following month to scale back their exposure to risky equities and scale up their exposure to riskless short-term Treasury securities. When the VIX returns to normal, advisors can shift their portfolio allocations back toward equities — though this can be difficult.

“Selling during a crisis is the easy part, the hard part is enticing clients back afterwards,” Moreira noted.

Aside from that challenge, advisors may be deterred from using the approach by other lingering questions. “Can these findings be replicated? How should they best be applied in terms of scaling up or down volatile assets? What happens to returns if everybody sells in response to volatility? What is the impact of taxes? Will these findings work going forward?” Adler asked.

 

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