Morningstar Advisor - June/July 2013 - (Page 63)

Gray Matters The Price of Managing Volatility By Rajneesh Motay Do riders with volatility controls cost VA investors potential gains? Insurers are increasingly limiting investment options in their variable annuities that have riders to strategies with built-in volatility management. Volatility overlays mitigate the risks for insurance companies by embedding some hedging within the investment strategy. But are investors who buy the riders giving up a portion of potential gains in return? We investigate this question by comparing two contracts with similar benefits; one with a volatility control overlay and one without an overlay. Targeting Risk Most asset-allocation offerings use the percentage of stocks to serve as a proxy for risk. These are commonly billed as “target-risk funds.” A “conservative” target-risk fund typically holds between 20% and 50% of its assets in stocks; moderate, moderategrowth, and growth options are analogously defined as portfolios with increasing amounts of equity exposure. This approach to investment-risk classification is reasonable because a portfolio gets more volatile as the percentage of stocks it holds increases. But risk here is understood in relative terms. Where this classification system falls short is in ignoring the absolute level of volatility. Exhibit 1 charts the rolling 30-day standard deviation of a “moderate” target-risk portfolio. It shows that the realized volatility was far from “moderate” during the difficult markets of 2008–2009, when standard deviation reached a high of 40%, a level of volatility that would have been unexpected even from an aggressive portfolio. That experience was an unpleasant surprise to most investors, and it drove many investment 63

Table of Contents for the Digital Edition of Morningstar Advisor - June/July 2013

Morningstar Advisor - June/July 2013
Letter From the Editor
Not Your Values
How Do You Use Alternatives for Clients?
Working to Build a Niche
How to Put Buffett’s Investing Philosophy into Practice
Sophisticated Strategies for the Masses
Investments á la Carte
Investment Briefs
The Percentile Trap
Defense Firms Will Stay Aloft
Beware the Lure of Diversification
Using Alternatives in Practice
Managed Futures and Cash Rates
The World Is Getting Grayer
Waiting to Pull Up Anchor
The Price of Managing Volatility
Let’s Get Back to Basics
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
Mutual Fund Urban Myths

Morningstar Advisor - June/July 2013