NO EASY -- OR CHEAP--REMEDY FOR VOLATILITY / BARRON´S MAGAZINE ( VERY HIGHLY RECOMMENDED READING )

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SATURDAY, DECEMBER 10, 2011

No Easy—or Cheap—Remedy for Volatility

By BEVERLY GOODMAN



Lots of new funds promise to remove uncomfortable price changes from your portfolio, but most are unproven and could be bad for your financial health.

The only thing more alarming than this year's market volatility has been some of the unsolicited advice given to investors who don't even understand the problem.

Several mainstream publications and television pundits have casually —and clearly without the benefit of much research—recommended that investors wary of market volatility try an array of expensive and unproven products. Among them: inversely correlated funds, which aim to provide the opposite return of a benchmark like the Standard & Poor's 500 Index volatility funds, which use a variety of options strategies to profit from volatility; and long/short and market-neutral funds, which (sometimes) attempt to limit losses due to volatility.


Perhaps the best indication that these strategies are growing increasingly faddish is the slew of new exchange-traded funds that have been launched in the past few months, including the iShares family of low-volatility ETFs, and Russell's low-volatility and low-beta offerings.


Volatility is certainly something investors need to be aware of. But first, you need to understand exactly what it is, and then you can decide what, if anything, you want to do about it—minimize it, capitalize on it, or ignore it altogether.


Standard deviation is perhaps the most commonly cited measure of a fund's volatility. Mathematically speaking, standard deviation measures the dispersion of a set of data from its mean. For mutual funds, the standard deviation measures how often a fund's returns have diverged from its average return. The larger the dispersion, the higher the standard deviation, and the more volatile a fund is considered to be. Like the returns themselves, you can compare a fund's standard deviation with that of the S&P 500 Index or other relevant benchmark.


But that doesn't tell the whole story. "Risk and volatility are not synonymous," says Shannon Zimmerman, Morningstar's associate director of fund analysis. "Some funds are more volatile than the broad market, but are actually less risky."


One good example: Oakmark Select (ticker: OAKLX). Manager Bill Nygren is a veteran value investor; he's interested only in stocks that are trading 40% below their intrinsic value. That leads to a pretty concentrated, blended portfolio of 20 growth and value stocks. The fund's three-year standard deviation is 22.21, higher than the S&P 500's 18.97, indicating it's more a volatile option when compared with, say, any given S&P index fund.


But take a look at the fund's upside and downside capture ratios, which, along with standard deviation, can be found on Morningstar's Website (under the "ratings and risks" tab). An upside/downside capture ratio measures how much a fund has outperformed (gained more than or lost less than) a benchmark. An upside or downside ratio of 100 indicates that the fund moved in lockstep with the benchmark. So its upside ratio of 128.61 for the past three years shows that when the market has been up, Oakmark Select has been up considerably more. The downside ratio of 105.26 in the same period indicates that while performance has lagged a bit when the market was down, it didn't lag by nearly as much as it outperformed in good times. In fact, Oakmark Select's three-year return is 22.31%, substantially ahead of the S&P's 13.16% return in the same period.


"CONCENTRATED FUNDS are generally more volatile than the broad market," Zimmerman says. "But if you overlay a good stock-picking strategy, like Bill Nygren's strict valuation criteria, it mitigates the risk, if not the volatility." Other funds whose standard deviations would indicate greater volatility, but that generally employ valuation strategies that dramatically mitigate risk and improve performance, include BBH Core Select (BBTRX), which invests in less risky blue-chip companies, and Leuthold Core Investment (LCORX), a quasi-quantitative fund that uses 179 qualitative and quantitative factors to compare the prospects of various asset classes with the risk-free returns of U.S. Treasury bonds.


"We're all overexposed to the immediacy of information, but too many people are suffering from recency bias," says Adam Bold, president of the Mutual Fund Store, an independent investment advisory firm. "A year and a half ago, every move in the market was attributable to the BP oil spill. When was the last time you thought about that in relation to your portfolio?"


Capitalizing on volatility has proven very difficult, as evidenced by the lackluster returns of both hedge and mutual funds that have tried. What's more, seemingly similar alternative funds can be quite different in investing philosophy. Not all long/short funds, for instance, are run with an eye towards minimizing volatility. Craig Callahan, president of ICON Advisers and manager of its ICON Long/Short Fund (ISTAX), says it's currently just 4% short. "We only short to make money, and we're not seeing enough overpriced stocks," he says. "We don't short to reduce volatility. It costs way too much. Volatility is caused by news events and emotions that show up in the market. You can't control any of that. And trying to control things you can't just ends up costing a lot."

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