I just returned home from the 20th Annual Global Indexing & ETFs Conference in Scottsdale, Arizona. Popular topics included moving beyond cap-weighted index funds, the growing search for yield and the increasing role of volatility in the management of risk.
The conference organizers had asked me to participate on the volatility panel and the moderator kicked off our panel’s discussion by asking, “What do we really mean by volatility?” The easy answer might include addressing the craziness, or lack thereof, in fluctuating asset prices. A more sophisticated response might differentiate between historical price movement and the risk of loss. For example, if Exxon Mobil drops from a $102 per share down to $74 per share because there are extreme price shifts in an underlying commodity in its business pipeline (i.e., oil), has the dividend aristocrat that pays 3% become more risky? Exxon Mobil's (NYSE:XOM) stock price, like oil itself, may become more volatile for a brief period, yet scooping up shares of XOM at $74 might actually be less of a risk than when it had traded north of a $100 per share.
Intrigue in oil price volatility notwithstanding, I felt the attendees would be better served to hear my perspective on what transpires in the real world; that is, Pacific Park Financial clients do not care to make the distinction between good volatility and bad volatility — they just want me to respond to “black swans,” “left tails,” or stock market Armageddon in a way that preserves the bulk of their portfolio dollars. After all, for regular folks, volatility and risk are one in the same.
Should we blame them? In 2000 and again in 2007, scores of endlessly bullish gurus misled their followers by touting volatility as opportunity. Take author James Glassman who wrote the bestselling Dow 36,000 at the height of 2000 euphoria. Few books have ever been less prophetic and more harmful. The same Mr. Glassman boasted about American International Group Inc (NYSE:AIG) in June of 2008 because the stock was down 30% and had a P/E of 6. Had you bought AIG on his guidance, you would have lost all of your investment in the company. And these are the people who love to tell you about “good volatility.”
In contrast, most people would rather see their portfolios fluctuate less. Need proof? Today, nearly $15 billion with a “B” rest within the coffers of “Low Volatility” ETFs. In contrast, “High Beta” or “High Volatility ” ETFs have struggled to capture the imagination of investors, bringing in a modest $250 million. Rightly or wrongly, it is clear what the public thinks about stocks with greater price fluctuations. It is part of the reason that iShares MSCI USA Min Volatility (NYSE:USMV) is featured prominently in my client accounts.
At the same time, funds like USMV should not supplant dynamic asset allocation pursuits. When stocks fall hard – when a bear finally arrives – I could hardly run a victory lap if a client has lost 35% when the market loses 40%. I have been hired in large part to reduce risk in bearish environments, raising cash in volatile downturns as well as shifting assets to safer havens. And while it is true that losing 15%-18% in this hypothetical scenario might not win me any awards, it will help my clients achieve their long-term goals; after all, one requires 25% to recover from a 20% draw-down, while one requires nearly 67% to recover from a 40% thrashing.
So what types of assets might I gravitate towards when stop-limit loss orders execute or when significant stock benchmarks breach respective trendlines? Over the last 25 years, I have found that certain assets and certain asset types minimize the volatility of stock ownership by their mere inclusion in a total portfolio. U.S. sovereign debt is typically beneficial (e.g., zero coupon, inflation-protected, long-dated Treasuries, municipal bonds, etc.). Well-regarded currencies from the dollar to the Swiss franc have been effective. The sovereign debt from influential economies like Japan and Germany also work. Commodities like gold have also served to offset stock scares.
When seeking ways to reduce “bad volatility” and the risk of significant loss, however, I prefer to employ a diversified basket of these assets rather than selecting one or two alone. I call it, “multi-asset stock hedging” and I believe the diversified approach is the only free lunch in stock risk reduction.
Recently, I partnered with FTSE to create the FTSE Custom Multi-Asset Stock Hedge Index (FTSE Custom MASH Index). One cannot reduce the uncomfortable volatility associated with severe stock sell-offs by investing in or trading the index directly – not yet, anyway. An exchange-traded note or exchange-traded fund could be available in 2015. In the meantime, I suggest that readers consider an equally weighted combination of the following funds for a portion of their overall portfolio:
PIMCO 25+ Year Zero Coupon US Tr. (NYSE:ZROZ)
iShares Lehman 10-20 Y Tr. Bond (NYSE:TLH)
iShares S&P National Mun Bond (NYSE:MUB)
iShares Barclays TIPS Bond Fund (ARCA:TIP)
RYDEX CurrencyShares Japanese Yen (ARCA:FXY)
Rydex CurrencyShares Swiss Franc (NYSE:FXF)
PowerShares db USD Index Bullish (NYSE:UUP)
SPDR Gold Trust (ARCA:GLD)
For those who may not have the discipline or desire to come up with an appropriate amount of multi-asset stock hedging, Pacific Park Financial offers separately managed accounts. I encourage interested individuals or groups to contact me about that alternative. Indeed, tracking the FTSE Custom MASH Index accurately requires the pursuit of Japanese Government Bonds and German Bunds on foreign exchanges.
One final thought regarding multi-asset stock hedging as it pertains to volatility and risk management. You do NOT have to be bearish on stocks to do it. Indeed, you may feel stocks are going to rise without a hitch for years to come. And yet, owning a basket of non-correlated assets in equal measure can still add value to your risk-adjusted returns. For instance, the FTSE Custom MASH Index is up 5.0% in 2014.
There were scores of excellent ideas and presentations at this year’s Global Indexing & ETFs Conference. Still, I found myself wondering why so many participants embraced the notion that central banks could permanently insulate them from severe stock losses in the future. Even in our breakout session on volatility, there had been more interest in “shorting volatility” than seeking ways to mitigate it or “go long.” It is for this reason that I have strongly supported a barbell approach throughout 2014, and will continue to recommend ETFs like Vanguard Extended Duration Treasury Bond Fund (EDV) for the left-hand side of the barbell.
Disclaimer: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.