Portfolios: Taming volatility

Occasional severe corrections are inevitable and even necessary to keep prices from becoming unrealistically frothy, Delfino says, in the same way that forest fires are necessary to clear out dead wood and make room for new growth.

Although your clients may grasp this concept intellectually, when the value of their investments sink, their emotions kick into high gear and they want to run for cover. But hiding on the sidelines hurts long-term returns, as those who fled the stock market after the 2008 financial crisis discovered when they missed the subsequent market recovery. (See chart at right.)

Advisors increasingly are adding asset classes and strategies to their offerings that are designed to smooth the bumps and keep clients from abandoning equities when markets plunge, including low-volatility and defensive stocks, protective put and call options, infrastructure investments and judicious use of short-selling.

Many of these strategies previously were the domain of institutional investors; now, they are available through mutual funds and exchange-traded funds (ETFs) to all types of investors.

“We are taking the principles of risk management from the alternative strategy/hedge fund industry and democratizing them,” says Som Seif, president of Toronto-based Purpose Investments Inc. Purpose offers a family of ETFs and mutual funds that includes several products designed to provide downside protection, including Purpose Multi-Strategy Market Neutral Fund.

Volatility measures around the globe have risen. The Chicago Board Options Exchange’s volatility index hit 30 on Oct. 15, about twice as high as long-term average levels. At one point, the S&P/TSX composite index was down by almost 12% from its 2014 peak and the U.S. S&P 500 composite index was down by almost 8%, although subsequent buying has moved these indices off their lows. Five of the 10 largest daily changes in the S&P 500 this year occurred in the past two months.

“Decisions that investors make when they are on the brink of retirement – which is where most baby boomers are – have a huge impact, as that’s when clients tend to have the most money,” says Keith Pangretitsch, director of national sales with Toronto-based Russell Investments Canada Ltd. “[These clients] become more concerned about losses as they move to the stage where they’re not earning any more money and are withdrawing from their portfolios.”

On the equities side of these clients’ portfolios, he adds, it’s important to focus on “defensive” stocks, as well as to diversify through some exposure to non-correlated assets such as infrastructure. For example, Russell Canada offers units in a global infrastructure fund that holds ownership stakes in an assortment of income-producing assets, such as toll roads and airports.

Although bonds remain an important portfolio stabilizer, Pangretitsch says, because of stronger economic growth in the U.S. and the increasing likelihood of higher rates, the 30-year bull market in bonds is winding down. Thus, traditional bond portfolios are “a less attractive diversifier” than in the past.

He suggests that clients also protect the fixed-income side of their portfolios. Strategies for this could include greater exposure to short-term securities or higher-yielding global bonds, as well as to “duration-neutral” strategies that may use some hedging techniques to protect against rising interest rates.

Russell Canada’s yardsticks for defensive stocks go beyond a “low-volatility” stock-price history; the metrics identify companies that show several years of consistency in earnings, low leverage, healthy returns on assets and growth in the business. In addition, companies with large amounts of cash on their balance sheets, such as Apple Inc. and Microsoft Corp., are in a position to pick up assets and take advantage of opportunities in an ugly market and will not be forced to raise capital by issuing new shares in a poor market.

Brent Vandermeer, portfolio manager and executive director with Ottawa-based Vandermeer Wealth Management, which operates under the HollisWealth Inc. banner, says that during market crashes, many clients forget that their stocks represent ownership in underlying businesses with value. And headlines about high-frequency trading give the impression of market manipulation and insider advantage, further stoking client fears, he adds.

“Short-term market moves can erode trust in long-term value,” he says. “Downside protection strategies are an important component of proper diversification and help in mitigating risk.”

Vandermeer sits down on a quarterly basis with his clients to review their financial plan and show them that despite market volatility, their well-diversified portfolios have been hurt less than the stock market indices and that clients still are on track to achieve their individual goals.

Among the products Vandermeer uses are retail mutual funds that take a value-oriented or low-volatility approach, as well as ETFs with built-in downside protection, such as Horizons Canadian Black Swan ETF and Horizons U.S. Black Swan ETF, both sponsored by Horizons Exchange Traded Funds Inc. of Toronto. (Black Swan-branded ETFs allow investors to maintain long-term exposure to either the S&P/TSX 60 or the S&P 500 indices and protect clients’ portfolios by investing about 2% of assets in put options on the same indices. The puts act as insurance, essentially locking in a selling price for the stocks.)

Vandermeer’s strategy protects against losses during significant market declines, but also allows participation in gains when the market recovers. According to Horizon’s research, there have been 12 occasions since 1982 that the Canadian stock market has seen monthly losses of 20% or more. Black Swan ETFs are expected to underperform their underlying index slightly in positive market conditions due to the cost of purchasing the options.

Achieving exposure to alternative strategies via mutual funds or ETFs also allows clients to purchase small amounts and to liquidate those positions quickly. In contrast, traditional hedge funds sold by offering memorandum, which are restricted to accredited investors, often require sizable minimum investments and lots of accompanying paperwork but do not always offer daily liquidity.

Several fund-management companies, including Sprott Inc., Dynamic Funds (owned by Bank of Nova Scotia) CI Investments Inc., Aston Hill Asset Management Inc. (all of Toronto) and Hesperian Capital Management Ltd. of Calgary offer funds that use alternative strategies designed to limit losses in bad markets.

“Volatility can create discomfort for both the advisor and the client, and using an options overlay in a fund is a good way to reduce that volatility,” says Kamran Khan, portfolio manager of Norrep U.S. Dividend Plus Fund (which is sponsored by Hesperian).

He employs a variety of put and call strategies within the Norrep portfolio to protect against the downside.

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