While volatility is an ordinary, and expected, part of financial markets, its latest incarnation has been extraordinary.

In Q1 of 2007, the VIX (the index measuring implied volatility on the S&P 500) began to climb, reaching a peak in November 2008 of 80.86—the height of the financial crisis. Since then, it has trickled back down but has remained well above its generally low historical levels (somewhere between 10 and 20 points). And, since the beginning of the summer, the index has been on the rise once more, with fluctuations between 30 and 40 points.

“Investors believe they should maintain exposure to the equity market because of the return potential,” says Robin Lacey, vice-chair with TD Asset Management (No. 1 on the Top 40 Money Managers list). “The hard thing is stomaching the ride sometimes, and this has been particularly true in the last three or four years.”

This unusual volatility has caused concern for money managers and investors. “The biggest challenge everyone is facing is not finding growth, but finding the asset that’s going to go down the least,” says Peter Lindley, president and head of investments with State Street Global Advisors (SSgA) Canada (No. 4). That explains the move into gold, the Swiss franc, the yen and, to some degree, fixed income, he explains. “Even low returns are better than negative returns, and I think that’s what people are concerned about.”

However, volatility may offer its own rewards. Astute managers can create new strategies to mitigate the volatility or take advantage of the opportunities as company stocks dip to attractive prices. Our 2011 Top 40 Money Managers Report shows only nine managers with negative returns, and overall, the Top 40 increased by 12.8%, compared with 6.6% in the November 2010 report.

Actions and reactions
Didier Borowski, head of strategy and economic research with Amundi, based in Paris, says volatility has had an impact on the firm’s investment strategy. “We had to be very cautious,” he says. “In terms of asset allocation, we reduced the risk exposure of our portfolios. We became negative on equities and positive on bonds against this backdrop.”

Amundi no longer has a directional strategy on either equity or bond markets, he continues, and now prefers equities that are more sensitive to the emerging cycle. “We believe that, in the current environment, emerging markets will be safer than the major developed markets.”

The soaring and plunging markets have also created a renewed interest in low-volatility strategies among institutional investors—and money managers are providing the solutions.

TD Asset Management, for one, has been developing risk reduction strategies for many years, in the form of low-volatility funds in both the fixed income and derivatives areas and, more recently, in equities.

In September 2009, TD launched its low-volatility (or minimum variance) Canadian equity fund and has since launched two more—the global equity fund and the all-world equity fund—using the same proprietary risk model. “By the end of this year, our clients will have committed more than $1 billion into those strategies since the launch,” says Lacey.

One of Amundi’s funds compares the volatility of indexes (e.g., the S&P 500 Index and the EURO STOXX 50). “The idea of this fund is to have a long-short strategy—so being long of one volatility and short of another one—and to try to put bets on some spreads [the difference between two volatility levels of securities or assets],” says Gilbert Keskin, portfolio manager and co-head of the volatility, arbitrages and convertible bonds team with Amundi. This fund provides cash plus 2% per annum with a limited risk. (The maximum value at risk is 4%.)

Other managers say they’re happy with their strategies as they are. Pier 21 Asset Management’s global equity strategy has been built for volatile markets, says David Star, founder, president and CEO. “In years of full bull markets, we’re very content to underperform a benchmark,” he explains. “We’re content to leave performance on the table in order to manage downside risk.”

Says Blaine Pho, senior vice-president, fixed income, with Greystone Managed Investments (No. 5), “While there is much higher volatility and a lot of uncertainty, it hasn’t affected our strategy because the actual liquidity in the market is still pretty good. It’s similar to other instances where you have a 20% correction in the stock market and corporate bond spreads may widen or back out.”

“Investors believe they should maintain exposure to the equity market because of the return potential” – Robin Lacey, vice-chair, TD Asset Management

Paul Moroz, head of global equity and global small cap equity with Mawer Investment Management, says that although Mawer has always focused on companies with strong fundamentals (i.e., a sensible business model and a strong balance sheet), it is particularly emphasizing these aspects in these volatile times. “We’re emphasizing, too, a lot on dividend yield—so realizing that we’re in a period of time where any one day the stock itself may be up or down, but you’re ultimately collecting that dividend, and that’s going to compound and pay dividends over time.”

High volatility can also provide opportunities for investment managers, says Gordon Gibbons, senior vice-president and portfolio manager with Leith Wheeler Investment Counsel (No. 27). “We’re picking off individual securities of companies that we haven’t had a chance to buy previously because of their valuations. We’re able to buy these companies at pretty attractive prices.”

Brookfield Asset Management (No. 19), which invests in infrastructure securities, has also found some advantages. “A water company, for example, doesn’t have its fundamentals impacted dramatically by a downturn in the economy—people still need water regardless of whether we’re in a bull or a bear market,” says Craig Noble, head of the global infrastructure securities business at Brookfield. “Nonetheless, we can see those stocks get whipsawed by the overall market, which presents some opportunities for us.”

Global view
One interesting aspect of the current environment is that global events are having a huge impact on market activity. For example, Brookfield has a bottom-up, fundamental research-driven approach to investing, but a portion of that approach is top-down. Noble says that Brookfield managers must be vigilant on the current macroeconomic issues—because that’s what is driving the stock prices.

And it’s those macro issues that many institutional investors are asking questions about. Andrew Marchese, head of Canadian equity with Fidelity Investments (No. 16), says he’s had questions from his clients about the European sovereign debt crisis and the outlook on U.S. economic growth.

“The third topic would be China,” Marchese adds. “For some clients, their concern is inflation in the emerging world and China’s policy in trying to stamp out that inflation.” Essentially, investors want to know how inflation will curb growth and what the impact is for commodities and resources-based stocks, which Canada is disproportionately exposed to, he notes.

But institutional investors are just going to have to hold on tight—because, according to most managers, the volatility will continue for the foreseeable future. “I think volatility is going to be here for quite some time,” says Marchese. “We’re living in a more global world where monetary policy and trade are more intertwined than they ever have been.”

“A lot of the underlying problems that led to this volatility have not really been solved or worked out,” adds Fran Kinniry, a principal in the investment strategy group with Vanguard in Valley Forge, Pa. “A lot of the issues that led to the July/August spike—the European sovereign debt crisis, the U.S. financial situation and what happens with the ratings agencies on U.S. treasuries and other sovereign credits—there’s not a clear path that says this is the way we’re going.”

Pension plan risk
But while the world waits for direction, pension plan sponsors have more immediate concerns.

While the investment strategies that lead to volatility in pension plan finances can help to provide significant returns over the long term, there is a downside. For DB plan sponsors, a major concern is their ability to plan ahead to the next fiscal year and beyond. In addition, the funding ratio may go down at a critical time for the plan sponsor. If so, the sponsor may go out of business and plan members may be left facing benefit reductions.

And, of course, DB plans are also subjected to actuarial valuations (at least every three years) to determine the financial condition of the plan for financial statements. These valuations can show a company in a negative light, therefore decreasing the stock price and potentially affecting bond ratings.

In this environment, pension plans are making concerted efforts to mitigate volatility with strategies such as liability driven investing and strategic or tactical changes to their asset allocations. But changing strategies can come at a price.

“The worse thing about extraordinary volatility is, you get a massive shrinking in liquidity and an increase in transaction costs,” says Lindley. “If we want to make significant changes to a portfolio, it could have a higher transaction cost in current market scenarios than in the past.”

Jim Gilliland, head of fixed income with Leith Wheeler, says he’s seen more focus on how a plan’s assets perform relative to its liabilities. And while some plan sponsors acknowledge that there’s going to be some volatility in the equity market, what’s been frustrating for them, he says, is when their fixed income portion hasn’t been able to keep pace with the liabilities.

That’s meant a lot of questions around better ways to manage a bond portfolio. Leith Wheeler is working with its clients on longer-duration mandates and looking at the plan more broadly in terms of the inflation risk, the structure of the liabilities and the possibility that a combination of corporate bonds—maybe strip bonds or a component of real return bonds—can be used to better meet those liabilities.

Similarly, SSgA has been recommending to clients to pick up returns where they can—“anything that yields a little bit more than normal bond markets [such as corporate credit] and doesn’t sacrifice credit quality,” says Lindley. “The last thing you want to do is buy poor-quality instruments of any kind, be they stocks or bonds.”

Lindley says he’s seen interest in lower-volatility stocks on a global basis. “We’ve developed some strategies with an approach that looks for the lower-beta stocks and searches to invest in those. The idea is that these stocks will not go down as much in down markets, but in up markets, they do almost as well as the other stocks that are higher volatility.”

And, in the last year, Lindley has also seen some institutional investors trying to reduce volatility by hedging their currency exposure. “Hedging [your currency] fully or partially can help reduce the volatility of the returns in that foreign currency when you translate it back into Canadian dollars.”

“We believe that, in the current environment, emerging markets will be safer than the major developed markets” – Didier Borowski, head of strategy and economic research, Amundi

Some institutional investors may look to diversify their portfolios with more esoteric asset classes, such as commodities or futures trading. “So what they do is try to use the last short period of time as a guide to what will happen next in the market, so they can make money in up and down markets and thrive in extremely volatile ones,” says Lindley.

Still, alternative investments have their own troubles, says Kinniry—particularly after 2008/09. “A lot of the more sophisticated investors replaced traditional bonds with more exotic diversifiers—private equity, hedge funds, commodities—and you saw fixed income mandates really drop. Unfortunately, a lot of the institutional investors said, ‘Wow, diversification let us down.’”

Kinniry sees the current environment as the revenge of traditional investment management—which basically says, don’t get too exotic. “In a global financial crisis and this August, the only assets that did well were traditional high investment-grade U.S. treasuries and government investments. If you thought you were going to get shelter in some of these other assets [private equity, hedge funds, for example], you were highly mistaken.”

As the wild ride continues, pension plan investors will need to get used to the fluctuations. But at least with some new strategies and tactics from money managers, they might be able to stomach the ride.

Brooke Smith is managing editor of Benefits Canada. brooke.smith@rci.rogers.com

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Copyright © 2019 Transcontinental Media G.P. This article first appeared in Benefits Canada.

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