When investors get concerned about market volatility, they typically head for cash or government bonds to derisk their portfolio. But while selling riskier assets may be a natural reaction it isn’t without its drawbacks. Moving to cash means giving up yield, and as is often the case, missing out on the market rebound. Here are three investment strategies that may lower volatility without the downsides of cash.
1. Move higher in the capital structure
When investors rotate from equities to cash, they are moving from the riskiest of asset classes to the safest. Yet there are many options that fall in the middle of this risk spectrum, including corporate credit. As initial losses are absorbed by equity holders, corporate bonds have a lower risk of capital loss versus equities, while also providing higher yields than cash. Historically, corporate bonds have also had a relatively low correlation to equities, providing diversification benefits. Of course, investing in bonds is still riskier than cash, and the price of bonds will fluctuate based on interest rates and corporate spreads. But for investors willing to maintain some risk, they may be a good middle ground between equities and cash.
2. Invest in flexible multi-asset strategies
Another approach is to include absolute return oriented strategies, which seek to generate positive or attractive risk-adjusted returns, with limited downside across market environments. Multi-asset strategies that have the flexibility to shift exposures across asset classes, depending on valuations and the market cycle, are one example of this approach. They enable investors to reduce equity allocations in periods when downside risk appears to be rising and access a diversified source of returns. Given the flexibility of these strategies, manager selection is critical. But if chosen well they can potentially enhance the overall risk-adjusted return of a portfolio.
3. Incorporate managed futures
The final option for portfolio derisking is to include alternative investment strategies. This can include a wide variety of approaches that typically share a low-to-negative correlation to a portfolio of equities and bonds. While these strategies often come in illiquid form, there are liquid options available too, and one of the biggest growth areas in recent years has been managed futures. Managed futures are trend following strategies that take advantage of momentum in financial markets. They have historically provided low correlation to riskier assets and can lower overall portfolio volatility.
None of these approaches is without risk. However, they all have the potential to lower portfolio volatility and provide downside protection. And if an investor can be more cushioned from market shocks, they may be less likely to play the lottery of market timing, and more likely to stay invested for the long run.
Learn more about strategies for derisking a portfolio: