Content provided by Case Eichenberger, CIMA, CLS Client Portfolio Manager
As portfolio managers, we are often questioned by clients about expected volatility and how we manage risk. This year is no different. Whether it’s nerves around the outcome of the U.S. presidential election, a perceived global growth slowdown, or dropping oil prices, volatility is all around us. When it shows up in the markets, investors often wonder if this time is different. But the truth is that volatility rarely differs from past shake-ups. Here at CLS, we expected volatility to increase this year, and as the chart below shows, volatility was likely to revert back to average in 2016.
So, what should investors do when volatility is on the rise and markets are unpredictable? Go to cash and wait it out? Get defensive with gold or long-term Treasury bonds? Dump international in favor of U.S. stocks? No, no, and no. Keep the Risk Budget in line to accomplish long-term goals? Bingo!
In fact, recommendations to decrease international in favor of domestic stocks come up more often than investors may think. It may make sense that lowering allocations to international stocks would lower volatility. As the chart below shows, international stocks (emerging markets included) are historically more volatile by measures of standard deviation.
However, that is not the case. We are missing one important aspect of portfolio management: correlation. Not all of the equity markets above are perfectly correlated, meaning they don’t always move in perfect unison. Below are historical correlations of equity (and bond) markets relative to the U.S. large-cap space. These show developed international stocks (EAFE) and emerging market stocks (EME) are not perfectly correlated with U.S. large-caps.
OK, so what? The whole idea behind global asset allocation is to lower volatility beyond U.S. stocks and allow for a better investor experience. By including assets that are not perfectly correlated, investors can lower the volatility of the portfolio. Does it work? A short and simple answer: yes.
Below is a chart from Vanguard, via the CLS: Why International white paper and our Quarterly Reference Guide. As it demonstrates, by investing upwards of 30-40% in international stocks, investors can lower overall volatility more than through U.S. stocks alone.
One last chart and we will put this one to rest. Below is an expansion of the second chart, with the inclusion of a few other asset classes, bonds, cash, and a globally balanced portfolio. Not only does the globally balanced allocation have less volatility than U.S. large-caps, it also has higher returns.
In short, the risk-adjusted returns are superior, and clients who are invested in globally balanced portfolios experience smoother rides and are much more likely to stay the course. Clients who are looking to reduce volatility would be better served by continuing to be globally diversified (or become more so) and paying attention to correlations of different asset classes. By decreasing international stocks and increasing domestic stocks, investors are likely to add volatility by increasing correlation.
CLS is a strategic risk allocator that makes active asset allocations depending on changes in risk and opportunities among asset classes. Here at CLS, we work hard to manage risk through our methodology of Risk Budgeting. We continue to be a global manager for strategic reasons (managing volatility) and for active reasons (finding opportunities). CLS is currently emphasizing international over domestic stocks.
JP Morgan on Correlations (Slide 54 of their guide to the markets)
CLS Global Balanced Whitepaper Callan chart (page 7)
CLS Reference Guide on lowering volatility with international stocks (page 13)
CLS 1st Q 2016 QMO on market volatility (attached)
CLS November 2016 monthly perspectives (page 4 and 5)
The graphs and charts contained in this work are for informational purposes only. No graph or chart should be regarded as a guide to investing. Correlation, in the finance and investment industries, is a statistic that measures the degree to which two securities move in relation to each other. A perfect positive correlation means that the correlation coefficient is exactly 1. This implies that as one security moves, either up or down, the other security moves in lockstep, in the same direction. A perfect negative correlation means that two assets move in opposite directions, while a zero correlation implies no relationship at all.