A Smoother Ride: Low-Volatility Equity Strategies
By John P. Calamos, Sr.

Advisors and their clients have found themselves confronted with new and longer-standing uncertainties in recent months—the slowing of the economic recovery in the United States and the looming shadow of a debt crisis in Europe figure most prominently. Against this backdrop, volatility spikes in the market have become par for the course. Many investors, therefore, are simultaneously afraid to be in the markets and out of the markets, as well.

Volatility and uncertainty are not reasons to stay out of the markets. If that were the case, there never would be a good time to invest. We expect volatility to continue, which we believe will bring opportunities. What matters is finding those opportunities and developing asset allocation policies along with investment strategies that address the current reality of the markets. Historical allocation of pure equities as a portfolio’s core may not be the most successful for many clients in this volatile environment.

We believe most investors should hold a portfolio that includes an equity component with lower risk than a traditional stock-only allocation. These low-volatility equity strategies may be appropriate for consideration as a new core to many portfolios, although these strategies too frequently are left out of the asset allocation discussion.

Defining Low-Volatility Equity Strategies
The objective of low-volatility equity strategies is to outperform the broader equity market with less risk than a comparative pure-stock portfolio. These strategies—which also are referred to as defensive equity strategies—utilize a blend of convertible securities and equities and historically have offered a lower-risk profile, with less market exposure and volatility, especially to the downside.

One way to measure the effectiveness of these strategies is to look at beta over a period of time. Beta is widely accepted as a particularly useful measure of risk. The low-volatility equity strategies discussed herein have betas that are near 0.70, compared to their respective indexes over a 10-year period of time, as of June 30, 2010. By reducing downside risk by nearly 30 percent, these strategies offer a potentially smoother ride through volatile markets.

FIGURE 1: STOCK VOLATILITY, S&P 500 INDEX, 90-DAY VOLATILITY, APRIL 1928 TO JUNE 2010

Source: Bloomberg

Over recent years, volatility spikes have left many investors discouraged. Staying on the sidelines isn’t a good response, nor is market timing. Instead, the best asset managers are navigating the volatility through a focus on quality companies and low-volatility equity strategies.
These low-volatility equity strategies seek to provide upside participation in equity markets with less exposure to downside than a pure-equity strategy. I personally witnessed their risk management profile during the sideways markets of the 1970s, the challenging environment of the early 1980s, and other recent periods—including the turbulent “mini-cycle” of 2008–2009—where these strategies outperformed their benchmarks.

This is not simply an asset allocation model with two different types of securities like a balanced strategy that blends some stocks and some bonds in a portfolio. Calamos’ approach to this type of risk-managed portfolio incorporating equities and convertible securities is designed to maintain an acceptable risk posture throughout a full market cycle. It can offer investors time in the market with a comfort level that neither stocks nor bonds alone can provide.

Thoughts on the Convertible Market
In 2008, valuations in the convertible market reached unprecedented lows. Now that the gap has narrowed, some ask what this means for convertible securities and strategies that utilize them. We believe the case for convertibles remains compelling, particularly when convertibles are dynamically combined with equities in low-volatility equity strategies.

Excluding 2008, the valuation gap still falls near the lows of the past 20 years. The gap is close to levels seen during the hedge fund-driven sell-off of 2004 and 2005, and is characteristic of recessionary levels. Within this context, current valuations in the convertible market imply opportunities again.

FIGURE 2: CONVERTIBLE VALUATIONS, JANUARY 31, 1990 TO AUGUST 31, 2010 


Source: Calamos Corporate System (CCS), Calamos Advisors LLC. Please note that the above chart has been derived from CCS, a proprietary valuation system designed and maintained solely by Calamos. While we deem the above information to be reliable, Calamos makes no public claims as to the validity of the information derived from the system.

It is important to remember that the undervaluation level referred to is a market average that includes a variety of overvalued and undervalued securities, and, in our opinion, active managers should not invest in the average.

When the valuation gap narrows, it simply means that uncovering opportunity requires a deeper understanding of the market and individual situations. Strategies that include convertibles do not add value solely through market dislocations, but through active management, which includes blending convertibles and equities to achieve a consistent risk/reward profile through market styles.

Conclusion
As we look to the remainder of 2010 and beyond, equity market volatility will continue to reach elevated levels. This is not an excuse to avoid the markets, but it is a reason to focus on strategies that can manage downside moves. Equity markets continue to be the best place for long-term investors and—for the most part—a necessary part of an asset allocation policy. Some investors might view the current volatility as uncomfortable, but we believe it is manageable. In our opinion, low-volatility equity strategies are a compelling starting point for managers who want to try and smooth out the ride for their clients—both now and in the unpredictable years to come.

To read our whitepaper on these strategies, "Low Volatility Equity Funds: Crafting an Asset Allocation," click here.

John P. Calamos, Sr., is the chairman, chief executive officer, and co-chief investment officer of Calamos Investments, and is the author of Convertible Securities: The Latest Instruments, Portfolio Strategies, and Valuation Analysis (McGraw Hill, 1998). Contact him at jpcsr@calamos.com.

Endnote
¹ As measured by the S&P 500 Index for our domestic strategy and by the MSCI World Index for our global strategy.

The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Information contained herein is for informational purposes only and should not be considered investment advice. Past performance is no guarantee of future results.

In addition to market risk, certain other risks are associated with an investment in a convertible bond, such as default risk, the risk that the company issuing debt securities will be unable to repay principal and interest, and interest rate risk, the risk that the security may decrease in value if interest rates increase.