Alts Democratized: A Practical Guide to Alternative Mutual Funds and ETFs for Financial Advisors, + Website

Chapter 16Volatility Management

Synopsis

Most approaches to portfolio construction manage volatility by offering a mix of stocks and bonds, and by using portfolio optimization based on the concept of an efficient frontier. The addition of uncorrelated liquid alternative strategies to the asset mix adds another source of diversification. Volatility management can be challenging to explain to clients, so we offer two illustrations of volatility drag that show how volatility can erode long-term returns.

We assume that most advisors are familiar with the efficient frontiers and portfolio management techniques based on mean variance optimization. This aspect of modern portfolio theory is well established, and is an excellent foundation for volatility management.

Adding alternatives to the portfolio has additional benefits, but only to the degree that the strategy is actually uncorrelated to the rest of the portfolio. Chapters 3 through 13 identify the different factor exposures of liquid alts funds, and most of them have high correlations to traditional sources of beta. Alternative Managed Futures Funds are one exception, since many of these funds are genuinely uncorrelated with stocks and bonds.

Unfortunately, investors often have trouble accepting the full implications of what it means to be out of sync with the market. Uncorrelated funds will lag during bull markets, and this can be difficult to explain to clients after a long period of high equity returns. This is why we like ...