But there is an alternative argument: in flat markets, with minimal economic growth on the horizon, volatility is the only way investors can make money. Can volatility be an investor’s friend?
Certainly volatility is not necessarily everyone’s idea of risk – risk for the majority of investors is losing money – and although volatility tends to rise in falling markets, a lot of volatility may also be seen in sharply rising markets. As a result, there are a number of investment strategies that benefit from just such a rise.
Given volatility is the largest component in options pricing, any fund strategy that makes use of options can benefit from an increase in volatility. Schroder Income Maximiser is a case in point, a fund that sells covered call options to enhance the yield of the fund. As volatility creates more uncertainty on asset pricing, people are willing to pay more for those options. This means the managers can improve the yield of the fund to a greater extent than they could in flat markets.
Historically, a number of absolute return strategies may also do well at times when there is lots of volatility, rather than if markets are strongly directional. Standard Life’s GARS Fund ticks this box.
In the long-only world, markets driven by fear and greed create opportunities for contrarians – like Jupiter’s Tony Nutt – who take advantage of market mispricing to buy into a stock’s recovery.
Another trend European investors are picking up from the US is volatility-based products that, in theory, benefit from market volatility directly. They are often simply ETFs based on the main volatility index, the Vix. While these should provide the perfect way to profit from volatility – the investor makes money as market volatility rises – problems with the way the Vix is rebalanced have meant significant tracking error on some of the funds.
Straightforward derivatives can also help investors profit from volatility by buying additional market exposure when markets have fallen or market protection when they have risen. Overall, perhaps the most important strategy to take advantage of volatility is to remain active. In markets that are flat, but volatile, as they are at the moment, a buy-and-hold asset allocation strategy is almost guaranteed to deliver poor returns.
Being active in stock selection and asset allocation is the only way to turn volatility to an investor’s advantage.
