Managing Portfolio Volatility

On the surface this may seem obvious, but it speaks to a bigger point.

I've talked before about every portfolio being vulnerable to something or a few things. Ever since the low in March it seems that the things that have struggled the most in these various pullbacks have been foreign/emerging equities, certain types of materials stocks and commodity related products.

The logic applied by the media is simple: with yields at zero, money is borrowed in USD and invested in foreign/emerging equities, certain types of materials stocks and commodity related products among other things in a risk seeking trade. Anything causing the dollar to go back up unwinds this effect regardless of what is the chicken and what is the egg and this has been called risk aversion.

Whether this version of the carry trade as spelled out by so many people accurately explains what is going on or not is not so important to me. It is a short term effect and when the dollar goes up, foreign/emerging equities, certain types of materials stocks and commodity related products seem to go down more than the broader market. This isn't important for people who are able to think in terms of the entire stock market cycle but it does create short term noise which has the potential for short term stress for people who have not thought about this ahead of time.

Long time readers will know that I am a big believer in exposure to foreign/emerging equities, certain types of materials stocks and commodity related products, but not a believer in huge overweights in these areas. Materials are only about 3% of the S&P 500 and, while we are overweight, we are well within single digits. Our exposure to commodities is mid single digits and our emerging market exposure is in the high single digits.

The idea here is trying to manage volatility. In a year when the market is up a little or down a little a small weighting to "the right" emerging country fund or individual stock could easily go up 50% or more. That can add a lot to the portfolio's overall return. Chances are that the best performer in a portfolio of 40-50 holdings will be up a lot more than 50% in a given year that, again, the market is up a little or down a little even if that return comes from the stock you would least expect. In my opinion, this contributes to the argument for small exposure to many holdings as opposed to large exposures to the things that "should" do well. This is because if you are wrong you will seriously impair your result.

There is an argument to be made that emerging markets "should do well." In the last month, as a microcosm, the iShares Emerging Markets Fund (EEM) is down almost 14% versus just 6% for the S&P 500. Some would advocate 20-25% of an equity portfolio should be allocated to emerging markets. At certain times that will create a lot of the wrong type of volatility. If you work with the numbers a little bit you will see that a little goes a long way.

That the portfolio is vulnerable to something should not be a worry in and of itself it should just be a matter of routine. All portfolios are vulnerable to something and occasionally that something will be exposed and you will lag--this is just how it is and so an emotional response is unnecessary.