Volatility in equities portfolios should be managed dynamically so that returns are not sacrificed in bull markets, says Adrian Banner, the chief executive and chief investment officer of Intech Investment Management.

Speaking in a session titled Smart Volatility Management in an Uncertain Market, at the 2017 Conexus Financial Equities Summit, Banner pointed out that volatility is volatile itself and that managing drawdowns requires some dynamic adaptation to the environment.

Given that tail risk hedging is expensive, and difficult to time, he explored the different approaches for managing volatility.

Banner said investors should start by asking how much they really want to reduce volatility.

“During a market crisis, reduce it as much as possible, but during a sustained bull market, too much volatility reduction is likely to sacrifice returns,” he said. “It may not be needed. Use portfolio construction, which is dynamic over time, and then you can reduce volatility when you really need to.”

The Australian-born boss of the $64 billion US-based Intech said investors interested in this dynamic adaptation model can use market volatility indicators to inform decisions on it.

“You can get some smooth outcomes over time without sacrificing returns,” he said. “It’s a simple idea: when the market volatility is low, back off. Then when volatility increases, start migrating to a minimum variance-like portfolio.”

In this way, he argued, the exposure to minimum volatility is dependent on how much volatility is in the market.

Banner said the current low levels of market volatility are unlikely to persist.

Intech runs a mathematics-driven process, which Banners said has difficulty identifying the driver of the current low-volatility market, but the culprit is “most likely” quantitative easing.

“We are in a low-volatility environment, we have had some drawdowns but recovery times have been very quick,” he said. “People have underestimated the tail risk from the geopolitical situation, but that’s hard to quantify. Some unforeseen event could wreak some havoc, and we probably couldn’t pick that up, but the portfolio would automatically start adapting.

“You don’t have to go on or off. If you get a little spike, like in August 2015, you can react a little bit without going the whole hog. This can minimise transaction costs.”

Banner said a well-designed process takes the environment into account.

“Essentially, a dynamic approach that moves as volatility changes can increase constraints as volatility increases, and decrease constraints as volatility decreases, so the portfolio “can go into alpha generating mode,” he said.

Conexus Financial is the publisher of Investment Magazine, top1000funds, and Professional Planner. For details on upcoming events, visit conexusfinancial.com.au/event.

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