Don’t throw in the towel; you can navigate volatility

Rochester Business Journal
October 16, 2015
Mark Armbruster
On Investing

Don’t throw in the towel; you can navigate volatility On Aug. 24, the Dow Jones Industrial Average fell more than 1,000 points within the day. This sort of volatility is what makes investors nervous—and question their commitment to their long-term investment strategies. Selling out of the market during downturns, however, is one of the most damaging actions an investor can take.

This raises the question of how to reduce volatility in portfolios so that investors are not tempted to throw in the towel at inopportune moments.

Certainly there is no way to completely avoid stock market volatility. After all, finance theory teaches us that it is the very risk of the market that allows for potential returns. Yet, there is evidence that undue market ups and downs can be mitigated through thoughtful portfolio construction.

Traditionally, investment portfolios have been limited to stocks, bonds and cash. But there are numerous other asset classes that investors can use. Hedge funds, in particular, have become a popular choice over the last 10 to 20 years.

The promise of hedge funds is that they will earn superior returns, reduce risk, or both. The evidence supporting these claims is sketchy at best. From 1995 through today, hedge funds have provided returns that are roughly in line with those of a traditional 60 percent stock and 40 percent bond portfolio. Interestingly, the correlation of returns between the traditional portfolio and hedge funds has been around 74 percent.

That means that three-fourths of the returns of hedge funds can be attributed to the returns of traditional asset classes. It makes you wonder if paying the often exorbitant fees of many hedge funds is worthwhile when you can get almost the same returns using basic stock and bond market index funds. The typical hedge fund fee structure includes a 2 percent annual management fee and 20 percent of excess profits, whereas index funds could be purchased with annual fees of less than 0.10 percent.

Hedge funds have had lower volatility than a more traditional portfolio, at least if you believe the data. The problem is that much of the hedge fund data is subject to well-documented statistical biases. Historical returns are overstated and risk is understated, very significantly it turns out. Many of the spectacular hedge fund meltdowns of the past are not reflected in the data, making returns look more stable than they actually are.