With big unknowns – how long the pandemic spread will last, and what the shape of an economic recovery may be – volatility appears to be the only certainty in the world today.

During these times of heightened anxiety in the marketplace, investors may need help to refrain from making emotionally driven investment decisions. Such panic selling can derail investors from their long-term financial plans. In fact, in the 2019 Natixis Investment Managers Global Survey of Individual Investors1 six in ten investors said they feel that volatility undermines their ability to achieve savings and investment goals. As a result, many are looking for investments that can help mitigate the risks associated with equity investing – along with their anxieties, according to David Goodsell, Executive Director of Natixis’ Center for Investor Insight.

“Nine out of ten investors told us it is important to protect their assets in volatile times. That feeling is so strong that, in an era in which fees on some passive investments have dropped to nearly zero, 56% of investors are willing to pay a premium price for an investment that could help protect them from volatility,” said Goodsell. Therefore, diversifying portfolios with strategies specially designed to help investors stay invested when markets get volatile may be a smart move.

Here are strategies to consider for potentially adding diversification and risk management benefits to investors’ portfolios.

Options to Dampen Equity Volatility
Options-based low volatility equity strategies designed to provide reduced downside risk compared to the equity market might be a good addition to risk-averse investors’ portfolios. Michael Buckius, CIO and Portfolio Manager at Gateway Investment Advisers, says his firm’s low volatility equity strategy has used index options to help reduce the risk of equity investing for more than 40 years.

Gateway’s approach is designed to deliver the majority of the long-term returns associated with equity market investments, but with less risk. It invests in a broadly diversified portfolio of stocks that closely track the US equity market, while hedging the portfolio with index call2 and put options.3 During the market’s reaction to the COVID-19 outbreak in late February and March, the Gateway strategy did its job, providing downside protection. “We plan for these types of markets. The plan we’ve implemented has shown that the risk management tools we lean on have been particularly effective in this volatile environment,” said Buckius.

A two-step risk management process helps smooth out the bumps during periods of turbulence. “First, the put options we use act as a shock absorber to help preserve capital when markets decline significantly. Our active approach allows us to capture the additional premium that comes with the market falling and volatility expanding. Secondly, and equally important, we buy back call options that are worth little and sell new call options at high levels of volatility, generating significant cash flow. This is a critical component that helps us grow out of losses,” said Buckius. Historically, Gateway has had its best periods of performance after the market goes through a period of stress, such as the 2008–2009 financial crisis.

Follow Trends and Crisis Alpha
In uncertain markets, trend-following managed futures strategies may help manage risk and diversify portfolios through their ability to go long and short4 on a wide range of assets. This type of alternative investment strategy has historically demonstrated the ability to maintain diversifying characteristics when most needed, in a market crisis.

Kathryn Kaminski, AlphaSimplex Group’s Chief Research Strategist and Portfolio Manager, explains how her firm’s managed futures strategy takes a systematic approach by following trends across global futures markets – in currencies, commodities, equities and fixed income. “Our trend-following strategies do not ask why something is moving. Instead, they ask what is moving and attempt to capture these moves. This is done by measuring the trend strength in different markets and sizing risk long or short as trends move over time,” said Kaminski.

During periods of stress, Kaminski says markets tend to be more synchronized and prices move in more predictable ways, leading to trends in different asset classes. “A common example is 2008 (see chart), which was a banner year for trend-following strategies as strong trends either long or short emerged in many asset classes in the wake of a challenging market environment.” This led to crisis alpha, which is considered a differentiating feature for managed futures relative to many other alternative asset classes. Some trend-following strategies have not only provided positive returns during historical crisis periods, but they actually seem to provide additional positive returns during these periods of crisis in excess of their average return in other market environments. This tendency is known as crisis alpha.

MSCI World Index and SG Trend Index 2007–2008
WEBINTAR206 0320 graph
Past performance is not necessarily indicative of future results.
Source: Bloomberg.

How have trend-following strategies navigated this difficult environment in 2020? “Short positions in energy and other commodities, long US dollar exposure, and long positions in fixed income have first offset and then began to outweigh losses in equity markets. It is also notable that the reduced trend strength in equities has also led to smaller losses in equities as the drawdown continued to extend. As trend signals have moved into the neutral to negative territory in equity markets, this position may be favorable should the ongoing disruption in markets continue,” said Kaminski.

Focus on Minimum Volatility
Actively managed equity strategies that take a holistic risk for return approach are rare. But that is exactly what minimum volatility strategies aim to do. For example, Seeyond’s minimum volatility approach selects stocks based on a multi-dimensional risk-based model, rather than their return potential.

Nevertheless, this doesn’t mean they have to sacrifice return potential, says Alex Piré, CFA®, Head of Client Portfolio Management for Seeyond at Natixis Investment Managers. Seeyond’s international min vol strategy has the ability to exploit a phenomenon known as the “low volatility anomaly” or the idea that, in aggregate, lower volatility stocks across all geographies can outperform stocks of higher risk over a full market cycle. “By working to exploit the low volatility anomaly, we believe our approach provides investors with the potential to generate strong absolute and risk-adjusted returns while experiencing less extreme return deviations,” said Piré.

For investors who find themselves overexposed to higher-risk equity investments after a 10-year bull market, a minimum volatility strategy may be a smart risk reducer to help stay invested through volatile times and on track to reach their long-term financial goals.
1 Source: Natixis Investment Managers 2019 Global Survey of Individual Investors, conducted by CoreData Research, February-March 2019. Survey included 9,100 investors in 25 countries.
2 Call options can reduce the risk of owning stocks, but they can limit returns in a rising market. A strategy’s use of options in managing volatility or in the pursuit of investment returns may not be achieved.
3 A put option buyer has the right to sell an asset at an agreed-upon price (“strike price”) within or at a specified time. The seller of the option has the corresponding obligation to buy the asset at the strike price if the buyer exercises the option within or at the specified time. The buyer of a put option risks losing the amount paid for the option if the price of the asset does not fall below the strike price. The seller of a put option risks losing the difference between the asset’s price and the option’s strike price, less the amount received from the sale of the put.
4 Long/short equity: An investment strategy generally associated with hedge funds involving the purchase of long equities that have the potential to increase in value and the selling of short equities that have the potential to decrease in value. A “long” position refers to the expectation (not guarantee) that an asset will rise in value, whereas a “short” position refers to the expectation (not guarantee) that an asset will decrease in value.

MSCI World Index: An unmanaged index that is designed to measure the equity market performance of developed markets. It is composed of common stocks of companies representative of the market structure of developed market countries in North America, Europe, and the Asia/Pacific Region. The index is calculated without dividends, with net or with gross dividends reinvested, in both US dollars and local currencies.
SG Trend Index: Equal-weighted, reconstituted and rebalanced annually. The index calculates the net daily rate of return for a pool of Commodity Trading Advisors (CTAs) selected from the larger managers that are open to new investment. AlphaSimplex Group LLC is part of this Index.

Risks: Options may be used for hedging purposes, but also entail risks related to liquidity, market conditions and credit that may increase volatility. The value of a strategy’s positions in options may fluctuate in response to changes in the value of the underlying asset. Selling call options may limit returns in a rising market.
Managed Futures strategies can be considered alternative investment strategies. Alternative investments involve unique risks that may be different from those associated with traditional investments, including illiquidity and the potential for amplified losses or gains. Investors should fully understand the risks associated with any investment prior to investing. Commodity-related investments, including derivatives, may be affected by a number of factors including commodity prices, world events, import controls, and economic conditions and therefore may involve substantial risk of loss.

All investing involves risk, including the risk of loss. Investment risk exists with equity, fixed income and alternative investments. There is no assurance that any investment will meet its performance objectives or that losses will be avoided.

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