Taking Cover In Volatile Times

Coverage of the 2016 Risk Management Conference

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story_images_ThunderstormWhat’s keeping Canadian plan sponsors up at night? The same issue that troubles most investors globally: market volatility. And for pension funds with little capacity to absorb drawdowns, it’s arguably an even bigger issue than it is for the typical investor. Sebastien Page, co-head of T. Rowe Price’s asset allocation group, argues that too much focus has been placed on trying to forecast returns in an effort to allay investor fears. Instead, he says, risk forecasting is “a much more effective way to understand portfolio management.”

One frequently asked question: Has volatility increased in the equity markets? Page argues that it has, using the U.S. market as an example. “Since the 1940s, the number of days when the S&P 500 Index moved up or down by three standard deviations or more has increased from an average 3 days per year to 9 days per year or more,” he notes. The result: fatter tails on the distribution of daily returns.

Page attributes this increase in big market swings to central bank intervention, which he believes has made markets more fragile. Add to that the increased use of derivatives, increasingly interconnected markets and the growth of high frequency trading, and you have a possible explanation for the persistent high volatility that has dogged investors over the last few years.

A standard 60/40 bond-equity portfolio will not cushion this volatility, Page contends. Investors need to look elsewhere. One possibility is to adopt a managed volatility strategy, which allows sponsors to de-risk their portfolios when market volatility goes up. “You might go as low as a
20 per cent equity beta in the portfolio or as high as 75 per cent, depending on your volatility target,” Page explains. Implemented as an overlay on an equity portfolio, a managed volatility strategy can lead to a much smoother ride, he says.

Using covered calls

Managing volatility is a valuable objective, but plan sponsors still need returns. Covered call writing can help enhance returns in the context of a managed volatility overlay, Page says. Combining a managed volatility overlay with a covered call writing strategy can be effective for plan sponsors because returns on the two strategies historically have been negatively correlated, he concludes. Thus, in his view, a combined approach can provide uncorrelated returns and risk management benefits when plan sponsors need them most.

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