Guarding against equity bears by investing in volatility

From 2013, equities markets have been characterised by low levels of volatility in the US. As an asset class, volatility is grossly undervalued, particularly when it comes to Asian equities. That Asia is now ground zero for all the financial turmoil in equities markets has refocused attention on the importance of volatility. Several issues have been responsible for increasing global volatility of late, including Puerto Rico's default, the restructuring of the Greek economy and the devaluation of the Chinese CNY.
This begs the question: Should we be focusing on diversifying financial portfolios at this juncture?

UNDERSTANDING VOLATILITY
Asian markets have seen trillions of dollars of value erased from their bourses in recent months. As a case in point, the Hang Seng China Enterprises Index has plunged almost 39% from its May high. Once equities markets face this kind of turmoil, market participants scramble for cover. Traditional safe-haven financial assets include things like government bonds and gold. The US dollar has also proven to be a preferred safe-haven asset during these tumultuous times. That the dollar is strong vis-a-vis a basket of currencies is also part and parcel of a longer term trend that has precipitated weakness in emerging market economies such as Brazil, Russia, India, China and South Africa. Nonetheless, investors are holding on to their dollars and short selling EM currencies. History has shown us that weak equities markets and high volatility go hand-in-hand. This knowledge can be used to great effect for investors with broad-based financial portfolios.

TRADING WITH THE TREND
We are seeing changes in the way that safe haven assets are being perceived. Many of the world's largest investment banks are buying high volatility instruments such as Chinese equity volatility. By purchasing volatility instruments, investors are hedging against sharp declines in equities. In order to profit off of volatility in the financial markets, one has to be able to identify and isolate it accordingly. Volatility instruments are distinct asset categories in the financial markets. In other words, traditional diversification methodology is being challenged by groups of investors ploughing their money into volatility assets. Sometimes this takes the form of opposite ends of the spectrum within the same asset class. You may go short on Asian equities and long on US equities, as an example. Alternatively, if you're trading in currency pairs, you may decide to short the CNY and go long on the USD. Trading with the trend is especially important during times of high volatility, since trends represent long-term patterns, especially where high volume is involved. It is not necessary to trade within the same asset class on opposite ends of the spectrum – one can do so across different asset classes by going long on US government bonds and short on US equities, for example.

WHAT’S DRIVING US EQUITIES INTO THE RED?
The goal with regards to volatility investments is to boost the overall value of a financial portfolio by taking opposite positions on assets. By going long on equity markets volatility at this point, and short on equities, one can protect an investment portfolio to greater effect. A caveat is in order with respect to volatility instruments: these do not function as a substitute for diversification into other assets. As such, volatility instruments are best perceived as accoutrements to your overall financial portfolio. They are especially useful to have in times where market uncertainty results in plunging equities markets. The mere presence of volatility instruments warrants careful consideration and evaluation by investors. One can never be too cautious when it comes to these instruments, and the advice and counsel of market experts is always a step in the right direction. The markets can never escape volatility – it is the one constant across all asset classes – currencies, commodities, indices and stocks. We need to be focused not on eradicating it, but on managing it for our own benefit.

SAGE FINANCIAL ADVICE
More and more, investors are feeling uncomfortable when it comes to long-term equities. The sheer scope of recent market meltdowns has effectively erased many of the gains that equities markets have racked up over the years. For example, the Dow Jones Industrial Average has a year-to-date return of -7.58%, and a 1-year return of -0.79%. The S&P 500 has a ytd return of -5.22% and a 1-year return of 1.23%, and the NASDAQ has a ytd return of -0.60% and a 1-year return of 6.57%. These figures suggest that in 2015 US equities markets – the world's biggest economy – are losing money. This is increasing the volatility in the markets which drives equities prices lower. It is clear that many investors are selling when they should be buying equities (better value). Rebalancing of financial portfolios is another important task that must be done. In other words you take assets from a strong performing asset class and move them into a weaker performing asset class. During times of high volatility the worst thing to do is to panic. Corrections are a normal market phenomenon and even bear markets turn around. Do not be lulled into a false sense of security by selling when the market is at its nadir – wait for the upturn. Successful investors always stay the course. To prosper during times of uncertainty diversified portfolios are an absolute necessity. One does not buy an asset that is performing well – the best technique is to strategise about which assets are likely to do well in the future and invest accordingly.

Please note that this column does not constitute financial advice.