Why volatility can be a good thing for investors

This article is part of
Outlook for 2016: What’s in store?

Investors should always be on the lookout for new ideas to improve the overall risk-adjusted return of their portfolio. These can include changing allocation to riskier or defensive assets, or diversifying exposures.

Volatility may not be an obvious choice, but it is an option to explore. A systematically managed volatility strategy can provide worthwhile returns, and do so with only modest correlation to conventional asset classes.

Most people think of volatility as a bad thing. It is assumed that higher volatility leads to higher risk of a negative outcome and as it is in our nature to be risk-averse, this tends to take the form of trying to avoid or hedge a loss.

Volatility can, however, be an investment opportunity and there are strategies that focus on exploiting bouts of market uncertainty to capture a return premium. Investors need to treat volatility like any asset that has a long-term expected return and a risk profile.

Investors should also bear in mind that periods of high volatility are usually short-lived. It is therefore key to focus on the important developments and ignore the transient ones.

Concerns around the Chinese economy and the government’s subsequent decision to devalue the renminbi was the primary driver of unusually high volatility in August. At the same time, in Western markets, volatility was also exacerbated due to the holiday season, which led to a lack of overall investment market activity. This period led to concern about a market correction and made nervous investors think about cashing out.

What investors should have focused on were the continued economic and earnings recovery and massive monetary stimulus. The short-term volatility should have either been ignored or used as a buying opportunity. While the widely favoured indicator of market volatility – VIX – reached its highest level in August for four years, those who held positions on VIX throughout August are likely to have done very well.

In August, the index returned a staggering 115 per cent, against the FTSE 100’s loss of 6 per cent. A similar episode occurred in late September when the VIX spiked again due to the uncertainty around the US Federal Reserve’s rate-tightening cycle and ongoing concerns regarding Chinese growth.

Employing a systematic investment approach and diversifying across a number of underlying volatility strategies has the potential to add value to an investor’s portfolio. Particularly in this low-return environment, investors should consider a number of different risk premia to achieve the desired risk/return outcome to meet their investment objectives.

Mayank Markanday is CFA, global equity research analyst at Russell Investments