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What is Managed Volatility?

As the name implies, Managed Volatility strategies seek to control the amount of volatility compared to traditional market cap weighted, relative return strategies. Their shared objective: participate up, protect down.

The Managed Volatility investment category has many billions of dollars invested, but the category itself is often misunderstood as there is no single definition, asset class, style, or approach. This confusion can often lead to misplaced expectations, and as a result perceived underperformance. A deeper understanding of the types of Managed Volatility strategies may help properly set investor expectations, and their role in portfolios.

Several Managed Volatility approaches have gained popularity over recent years, as investors seek greater control over their return profiles. However, their characteristics are very different, as are their abilities to participate up, and protect down.

Popular Managed Volatility approaches, and how they work

• Fundamental Weighting: This involves weighting portfolio positions according to one or more accounting-based measures such as assets, revenues, earnings, cash flow, or dividends, rather than using traditional capitalization weighting; hence the name fundamental weighting. More weight goes into stocks with value characteristics (lower P/Es, higher yields, and so on).

• Low or Minimum Volatility Portfolios: A more mathematical approach that is related to fundamental weighting, and is commonly known as low volatility, minimum volatility, or minimum variance. Rather than using accounting-based measures to weight portfolio positions, these strategies weight the portfolio according to some specific measure of volatility, such as beta, so the higher volatility stocks get less weight or are excluded. Alternatively, a min-vol or min-var portfolio can be built directly using a formal risk model. In this case the objective for the overall portfolio is to produce the lowest forecast risk from the optimal mix of stock holdings.

Risk Parity: This approach is based on the same concept of diversification as traditional portfolio management. However, it avoids the problem of lower-risk assets diluting overall returns, by using leverage. This maximizes the benefit of diversification,because all assets contribute equally to volatility. Meanwhile returns are kept high because the return contribution from lower-risk, lower-return assets is amplified. A risk-parity portfolio would add more bonds using leverage (i.e. without reducing stocks) — enough additional bonds to make their effect on portfolio risk the same as that from stocks.

Options Based Strategies: Approaches using options, or option-like instruments such as credit-default swaps (CDSs) and other d erivatives can reshape the return distribution, rather than simply scale risk and return up or down. Unlike the three previous strategies, the focus can be on downside protection. The pattern of returns that investors would like to see has the hockey stick profile of a call option, participating in positive returns, but not in negative returns. This is a form of insurance: when your house (portfolio) burns down, your insurance (the option) protects you, and you are not liable for the cost of rebuilding (recovering the losses). In fact, a simple way of implementing this strategy when you own the underlying asset is to buy explicit insurance in the form of a put option as an overlay on the portfolio. The combination of a long position overlaid with a put behaves exactly like a call option. Of course in practice these strategies can be much more complex, using a variety of options, swaps, etc. to achieve the desired effect.

Dynamic Risk Balancing: This is a disciplined quantitative strategy that relies on the predictability and persistence of volatility, especially downside volatility or left-tail risk. Managers use statistical analysis of various volatility related signals to identify periods when the risk of large market declines is high, at which point they reduce exposure, move to less risky assets, or even go short. Conversely, when the signals indicate a risk environment with a higher chance of market increases. the exposure to riskier high-return assets is raised.

Which approach does the IronGate use, and why?

The IronGate Risk Managed Core Diversifier uses Newfound Research ‘s proprietary Dynamic Risk Balancing approach for several reasons:

• Simple: No shorting, No Leverage, No Derivatives

• Provides tail-risk management: A key advantage of a Dynamic Risk Balancing approach is the ability to focus on downside risk independently from upside risk. In fact many investors are puzzled by the concept of asymmetric returns. In reality, they are happy to take on upside risk or volatility; only downside risk or volatility is problematic. And it works best when it avoids the flawed assumption that financial markets have a normal distribution of returns and accepts the existence of fat tails, and common extreme events. Independently analyzing extreme downward market moves and their associated patterns of downside volatility can yield critical insights that are missed when simply analyzing overall volatility patterns.

• Adaptive, Simple, Robust, Reactive: a re important elements to a successful longterm investment strategy, especially during periods of heightened volatility, with severe and more frequent drawdowns. Not dependent on strong economic growth, and low or declining inflation for strong returns.

• Strategy Indexes: A rules-based strategy allows for a single solution to be indexed, while also being adaptive to the market environment. The risk managed focus enables it to be a relative return strategy in up markets, and absolute return focused in bear markets.

In summary, the concept of managed volatility is an appealing one, especially in riskier asset classes such as equities, and commodities, and in a rising rate environment for bonds. Reducing downside risk while preserving upside potential dramatically improves compound returns. However, there are several different approaches that can produce widely varying results. Some vary the weights of the holdings to produce lower-volatility portfolios. Others use leverage to maximize the benefits of diversification. Others employ options and other derivatives to provide downside protection. Still others use dynamic techniques to rotate between higher and lower risk instruments based on market conditions and forecasts of volatility. Since these are not all mutually exclusive strategies, and since some apply mainly to stock portfolios while others are multi-asset in nature, it is possible to incorporate more than one. In todays volatile world the concept of managed volatility is clearly one whose time has come.