Volatility; Friend or Foe?

20 May 2015

In finance, volatility is often defined as the historical standard deviation of an asset price, or in other words to what extent an asset return has deviated from its historical mean over a given time period.

Volatility of an asset reflects its inherent risk; an asset with high volatility more often exhibits significant price fluctuations, both on the upside and on the downside. This makes the asset riskier as an investor faces a higher probability of making losses compared to investing in less risky assets whose historical return have tended to cluster more closely around a mean. At the same time, the wide dispersion of returns of the riskier asset means there is also an opportunity of stronger performance.

Market volatility (i.e. aggregate price volatility of multiple assets) tends to vary over time and is driven by among other things the business cycle and shocks such as the Lehman Brothers bankruptcy. In this case, volatility picks up for the market as a whole which affects all asset classes to some extent. Naturally, asset classes that are more volatile (such as equities, which represents companies’ risk capital) would be more affected than less volatile asset classes (for example UK or US government bonds where the payments are guaranteed by issuers with good financial strength).

Volatile markets might offer opportunities for certain types of investors as a sudden fall in valuations across the board can push securities temporarily into undervalued territory. If these are bought at depressed prices and sold again after markets recover, a profit can be made. These strategies tend to be employed by investors with a short-term focus who have appropriate frameworks in place to frequently make tactical investment decisions (for example hedge funds or other active unconstrained asset managers).

Trustees of pension schemes are investing for the long-term, and therefore, are generally not geared-up to make short-term tactical investment decisions. Such decisions are more efficiently delegated to active unconstrained managers, for example diversified growth fund (DGF) managers or other multi-asset managers, who implement strategies to manage volatility and take advantage of short-lived opportunities within robust risk management frameworks. Trustees with exposure to active unconstrained funds could therefore already see part of their portfolios positioned to take advantage of bouts of increased price volatility.

In addition to delegating tactical investment decisions, Trustees that have implemented de-risking programmes based on mechanistic triggers remain well placed to increase their allocation to matching assets (which typically reduces total portfolio risk) as and when opportunities arise. These opportunities could appear (and disappear) quickly. For example, opportunities might arise if the outlook for gilt issuance changes. We recommend all Trustees to consider whether this approach is suitable for their circumstances.  

Furthermore, Trustees investing in dynamic Liability Driven Investment (LDI) products  could also stand to benefit from the potential that the relative pricing of the available hedging instruments vary more than usual. Trustees seeking more information about any of the above solutions are recommended to speak with their Investment Consultant.

Within their framework as long-term investors, many well-advised Trustees take advantage of unconstrained active management (such as DGFs) and have geographically diversified portfolios (also reducing region-specific risk). Dynamic de-risking strategies, including dynamic LDI strategies within portfolios should also help Trustees weather a period of higher than normal volatility in financial markets.

We also recommend exercising caution when it comes to new investment and disinvestments. Capita has a fully dedicated asset transfer team, who continuously assesses whether trading is advisable under any given market conditions. This process involves making recommendations whether it might be better to hold off non-essential cash flows and transitions until the dust settles after a period of volatility.

As a conclusion, we suggest that Trustees do not let market jitters tempt them to make short-term investment decisions. Rather, the exploitation of these opportunities should in most cases be delegated to an unconstrained investment manager or operated via a mechanistic framework. Financial market volatility can present opportunities as well as challenges, and we recommend Trustees to engage with their Investment Consultant for more information on how they can capitalise on this and make volatility a friend rather than a foe.

Written by Albert Küller, Chief Economist and Christian von Canstein, Investment Analyst

This document has been prepared for your general guidance only and has not been produced for your specific purpose.  It does not constitute professional or legal advice and should not be relied upon as such. The contents of this document, current at the date of publication, are for reference purposes only. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this document and to the fullest extent permitted by law, we accept no liability and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this document or for any decision based on it. Unless we provide express prior written consent, no part of this document should be reproduced, distributed or communicated to any third party.

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