Embracing opportunities: how volatility can make private investors money (afr.com)

Rocky markets can throw up unique opportunities for nimble investors.

After years of low interest rates and quantitative easing suppressing market volatility, the re-emergence of inflation and an aggressive tightening cycle has seen volatility reappear with vengeance. For private wealth investors, volatility should not be feared and but embraced as an opportunity.  Volatile markets can throw up unique opportunities for nimble investors and entering these opportunities at the right point in the cycle can add significantly to a longer-term wealth accumulation strategy.

While most investors intuitively know that they need to take risk to generate investment returns, the psychology of witnessing large fluctuations in market values can be debilitating even for the most seasoned investor.  While having a long-term investment plan can provide some comfort for private investors at these times, an overreliance of “time in the market not timing the market” can leave investors feeling a little unsatisfied.  Entering investment ideas at depressed valuations can really turbocharge your investment returns.  But you need to be alert to the opportunities and have the capacity to move quickly when they present.

Risk comes in many forms.  In market speak - volatility is simply the rapid and erratic price movements of financial assets within a specific timeframe.  It is an inherent aspect of markets, driven by a multitude of factors such as economic indicators, geopolitical events, and investor sentiment.

Investors often feel more comfortable with an investment if its volatility appears low.  But looks can be deceiving and volatility can seemingly spring out of nowhere.  In the bond market, the so-called riskless asset class, volatility has spiked, and returns collapsed during this tightening phase. The ripple effect has been felt in the UK Gilt market and more recently by US regional banks.

And those investors who bought unlisted assets because of their advertised low volatility are now having their investment thesis challenged.  Capital withdrawals from many of these funds are now restricted as the gap between the market pricing of assets and the model valuations has become too extreme.  Simply, it is too detrimental to simply allow unit holders to exit funds at unchanged valuations and the upcoming reset may prove to be brutal.

But as Warren Buffett once said, "volatility is not the measure of risk; it's the measure of opportunity."

For those investors who have built up cash reserves and have firepower to deploy, there are always opportunities in these types of volatile markets.  Bonds are now at more attractive levels and cash plus style strategies are generating decent returns.  Special situation funds in the property sector that can take advantage of distressed or broken deals can generate equity style returns with bond levels of protection.

Beyond the more traditional styles of investments, more sophisticated investors may also consider a prudent allocation to more complex volatility strategies.  Volatility strategies aim to capitalise on the price fluctuations and inherent uncertainty in financial markets. Rather than avoiding volatility, these strategies embrace it as a source of opportunity. There are various approaches to volatility strategies, including volatility arbitrage, options trading, and range of widely available managed funds.

Volatility arbitrage is a trading strategy that exploits pricing discrepancies in options' implied volatility. It involves simultaneously buying and selling options to capitalise on mispricing. Traders aim to profit from these disparities by establishing delta-neutral positions, trading calendar spreads, or identifying opportunities in volatility skew or dispersion trading.  Options are another trading tool that professional investors can use to profit from market swings. Strategies like selling covered calls (selling a call option in a stock that you own with a strike above the current share price) can generate additional income during uncertain market conditions.

There is no shortage of managed funds that claim to take advantage of heightened volatility in bonds, equities, and currencies. Here, manager selection is the key and a thorough due diligence process evaluating past performance, risk management techniques, and actual skill are all vital factors in the selection process.

Determining the appropriate allocation to volatility strategies is crucial. A well-diversified portfolio typically includes a blend of asset classes, and the allocation to volatility strategies should be based on individual risk profiles and investment horizons.

While embracing volatility can be advantageous, it is crucial to exercise prudent risk management. Setting realistic investment goals, diversifying portfolios, regularly reviewing holdings, and maintaining a long-term perspective can help mitigate the potential downsides associated with market turbulence.  But as Mark Zukerberg famously said, “in a world that is changing really quickly, the only strategy that is guaranteed to fail is not taking risks”.