Wealth Matters: Investing in Volatility, to Cash In or to Hedge Bets

But while most investors care about volatility only when markets go down and their portfolio loses value, volatility works both ways. And smart investors are figuring out ways to smooth out the peaks and valleys.

Tony Roth, head of wealth management strategies at UBS Wealth Management, said he considered volatility a fourth asset class, after stocks, bonds and alternative investments like real estate and hedge funds. And he advises the firm’s wealthiest clients to factor it into their portfolio even in good times.

“You’re competing in a market with high-speed and hedge fund traders, and they have volatility strategies as a source of returns,” Mr. Roth said. “If you’re not developing your own strategy for dealing with volatility, you’re at a structural disadvantage on the playing field we call financial markets.”

While thinking of volatility as an investment may seem as odd as buying air rights for development once did (or still does), devising strategies that limit the highs and lows in the global economy are becoming common. They generally fall into two categories: strategies that look to profit from volatile markets and those that try to cushion a portfolio from those wild swings.

What has changed is that many of these strategies are no longer available only to the most sophisticated investors. (Some of them certainly got a lot more expensive this week.) Two of the strategies I discuss below are accessible to investors with even modest portfolios and two are for wealthier investors, but they show just how much control people can now exert on their returns.

Here’s a look at the strategies aimed at giving investors more control over their returns, though, of course, there are some risks.

COLLARS The simplest volatility strategy is combining two types of options to create a range a stock or an index will trade in. This is done by selling a call option, which allows the buyer of that call to purchase shares at a set price, and then buying a put option, which allows the person who owns the shares to force someone else to buy them if they fall to a certain level.

Take United Parcel Service, which was hovering around $63 a share on Monday, the first day of trading after Standard Poor’s downgraded the United States’ credit rating. Tyler Vernon, chief investment officer of Biltmore Capital Advisors, which manages $600 million for wealthy families, said that an investor could have sold a call option at $65 a share for $2.50 and for the same amount bought a put option at $60. The costs would cancel each other out and the investor would have created what is called a collar around the stock.

“With volatility kicking up, this is a strategy that more sophisticated investors are taking advantage of,” Mr. Vernon said. “They’re O.K. giving up the upside after seeing markets fall down by hundreds of points every day.”

Of course, the investor may not get the gains if the U.P.S. stock rises above $65 before the collar expires. But Mr. Vernon said this was a risk most clients were willing to take. “They’re having flashbacks to 2008 at this point, so that’s not a bad deal.”

FUTURES CONTRACTS A slightly more complex but relatively inexpensive way to manage losses is to buy futures contracts that bet an index will fall in value.

Mark Coffelt, who manages the Empiric Core Equity Fund, said he hedged the entire $50 million portfolio this week by buying 702 contracts that bet the Russell 2000 index, which tracks small-cap stocks, would fall in value. They cost just $1,400. While the equities in the portfolio still fell in value, the futures contract limited the overall losses.

“Our hedges picked up $2.5 million” the previous week, Mr. Coffelt said. “Hedging has helped us tremendously this year. It has not accounted for all the gains, but it sure has reduced some of the losses.”

A big advantage of this strategy is that the markets for futures, particularly with currencies, are easy to trade in and out of. But they require restraint.

Article source: http://feeds.nytimes.com/click.phdo?i=4690e71acb4b12da44e42eaea012f2f8