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Questions of volatility in Europe and beyond

2018 saw the return of volatility, and after a bumpy January, things have settled down and markets have continued their march higher, argues Gilles Prince, CIO Switzerland, Edmond de Rothschild.

Questions remain about volatility, however. Such as: How much longer can this last? What can investors expect? How can you make money on volatility? Should Investors be looking to futureproof portfolios from volatility?

Common sense must prevail

Volatility lies at the very heart of any investment portfolio, in a positive and in a negative way. It is one of the key ingredients for a quantitative portfolio construction, which, if properly understood, allow the construction of robust and stable portfolios.

But it is far from being only a quantitative exercise. The sources of volatility need to be understood in order to achieve true diversification. Statistics may be unstable and hide their true nature in calm market environments.

For instance, two similar regional equity funds would share the same sources of risk and hence offer little diversification in a market shock.

Mixing risks and not relying blindly on statistics is therefore the first step for constructing robust portfolios. In other words, common sense first.

Then, leaving aside asset allocation considerations, portfolio construction engineers incorporate each position risk to define its weight. Looking at its individual potential loss impact on the portfolio is a good starting point.

That is done simply by estimating the position potential drawdown using volatility, value at risk, or any technical analysis measure. The loss estimation gives us an idea of the impact a position can have on the total portfolio, and helps decide on how much capital one is ready to lose over the considered period.

It is a crude measure of risk as it does not incorporate diversification effects, but it gives a useful and conservative estimate of the impact of an investment going the wrong way.

Gong a step further

Going one step further, diversification effects are added to assess the position risk given its correlation with the rest of the portfolio. As some position may have a less than perfect correlation, their risk impact is less than individual losses calculated above.

A negatively correlated asset may even reduce portfolio risk despite its maybe higher volatility. Volatility is good in that case as it increases the natural hedging properties of that asset. The limit is that correlations are not stable during crises and may lead us to underestimate risk.

The two approaches are therefore nicely complementary and help building a portfolio less prone to unexpected volatility.

"Volatility lies at the very heart of any investment portfolio, in a positive and in a negative way."

In the current market environment, such an approach shows all its validity although it has become at times psychologically more difficult to implement.

Sovereign bonds act as an anchor in most balanced portfolios due to its low correlation and safe haven properties and are must-hold assets. But as interest rates fell to negative levels, it has become quite difficult to find valid economic reasons to invest in bonds that promise buy-and-hold investors a sure loss.

Therefore, one of the main reasons to hold those bonds is for its hedging properties in portfolio. But negative interest rates also have a secondary effect on portfolio construction. The so-called search for yield made fixed income investors consider riskier assets in order to achieve positive yields.

Cocos, hybrids, credit derivatives, structured credit, private debt, or leveraged loans can be found in many standard balanced portfolios today with the only objective to maintain an acceptable expected return.

Although it may be hidden today, risk levels have generally increased, which may in the end lead to bad surprises as risk is more concentrated than intended.

The mistake to avoid

Portfolio structure is therefore more important than ever to face recurring market panics, sudden trend reversals or, in other words, volatility.

Sentiment is driving market gyrations more and more and an aptitude to build robust portfolios able to navigate through market stress has become key.

"Mixing risks and not relying blindly on statistics is therefore the first step for constructing robust portfolios. In other words, common sense first."

Overreacting to volatility events is a mistake we want to avoid. Understanding the sources of risk affecting your portfolio is needed more than ever.

Gilles Prince will be speaking on playing the volatility game at Inside ETFs Europe in London on October 7. 

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