Using Volatility to Your Advantage

12/04/2012 9:15 am EST

Focus: MARKETS

Most investors see volatility as risk, but these words aren't synonyms, and can be quite the opposite, says Stephen Hammers of Compass EMP Funds.

Gregg Early: I am here with Stephen Hammers, co-founder and CIO of Compass EMP Funds. Today we’re talking about volatility. Stephen, is there any great advantage to looking at volatility when buying into sectors or the market in general?

Stephen Hammers: I think it’s very important, and let me give you the reason why. When you look at stock investing, most portfolio managers might look at what they feel are the best ideas, but some of those best ideas may also be the most volatile stocks.

If you look at the S&P 500, for example, and you look at its volatility—about 84% roughly, 80% to 85% of the S&P’s return comes from the top few stocks—what that does is it dictates your return by where money is going in and out, which creates higher volatility. If most money managers don’t have those top few stocks, they can either underperform or outperform the benchmark.

We believe on taking risks to another level and managing it appropriately, where if you look at all the stocks in the stock market, you weight them based on their risk contribution. It is amazing what you can get in terms of risks and return.

Gregg Early: So it’s definitely a step beyond simple valuations, and it's an important aspect that’s overlooked by people simply looking at fundamentals.

Stephen Hammers: It’s very important. Now, fundamentals are important, because earnings drive stock prices. So in the CEMP Volatility Weighted Indexes that we created many years ago and have now had patented and published through Dow Jones, these indexes look first at if you don’t make money consistently each of the last four quarters. If you don’t have positive earnings, you don’t even qualify for the index.

That’s kind of a novel concept by itself. But once you have those stocks that qualify, they make money, and if you look at the large-cap segment of the market and you equalize the risks on all those stocks, the returns are actually quite astonishing.

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When you go back to 2000, every bull market and every bear market we’ve seen since 2000—and we’ve seen several—volatility-adjusted investing beat the S&P in every bull market and every bear market cumulatively six times over in terms of return, but with less risk. You got to make money and you equalized the risk. Volatility is very important.

Gregg Early: Is it only effective with large-cap stocks, or can you use this with other sectors?

Stephen Hammers: Well, it’s actually very effective even with small-cap stocks. You know, if you look at our CEMP Volatility Weighted Index and compare the Russell 2000 and you go back ten years, you have a return of 175% versus 64% with a lot less risk. So it really applies to small cap, international, emerging market, even commodities.

Commodities...the thing that frustrates me the most is when most people talk about the commodity market. Mainly and unfortunately, the subject usually only consists of oil and energy. The Goldman Sachs Commodity Index is over 70% energy. You might as well throw that up against an oil ETF and that’s what you get.

We look at the 20 most liquid commodities, but equalize the risk in all commodities, so whether it’s oil or wheat or cattle or silver, it doesn’t matter. They all have the same contribution, so it’s a much better picture of the broader market...and 100% of every bear market, going back to the 70s, weighting based on risk has done significantly better than weighting based on production or opinion.

Gregg Early: You launched a number of funds recently with this volatility focus, correct?

Stephen Hammers: We actually launched 13 mutual funds. Nine of them follow our index, or track the performance of the index, which is weighting based on risk. And it is important to understand, these aren’t low-volatility indexes. Those indexes only look at the low-volatility stocks.

What happens there is you don’t have the broader market, so there’ll be times where you do better and times where you do worse. We represent every asset class out there, many of which focus on the risks of all the different securities in those markets and in those sectors.

We limit country. You have to limit country exposure, because if you look at the MSCI EAFE, which is an international developed market index, 40% is Japan, so it’s all based on what is Japan doing. We actually limit that risk on the country, so if you look at performance and risk, you have much, much better risk and return characteristics.

Gregg Early: It also sounds like using this volatility screen, it allows you to better invest across these sectors without ending up, like you said, in the commodity sector, ending up energy-heavy, or in the emerging market sector or Asia sector and ending up Japan heavy.

Stephen Hammers: Yes, that’s exactly right. Let me give you another example on large-cap stocks. If you remember back in the late 90s, the S&P 500 technology sector took over. Technology rose to almost 40% of the S&P—and you know the old saying, “what goes up more, falls more.”

Well, the bear market of 2001 and 2002 was about technology, so it overweighted based on where people were going. If you look at 2006-2007, the highest sector was financials. It got up around the 35% to 37% range. When you weight based on risk and you require those companies to make money, you don’t get into those market fads like the S&P 500 does, therefore you performance is significantly better.

This CEMP index did not decline; actually it declined 0.63% in 2001 and 2002, when the S&P declined over 36%. When you manage risk and you control risk, you have much, much better risk-adjusted returns, and you don’t dramatically overweight certain areas. Eventually that can create more volatility and come back and bite you.

Related Reading:

The Flip Side of Risk

The Dollar's Surprising Future

Even Long-Term Investors Should Hedge

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