Volatility is an ever-present reality in financial markets that can yield losses or gains depending on the investor’s approach. This volatility emerges from conditions that include economic instability, geopolitical events, changes in interest rates, and company-specific performance. While volatility presents a risk, however, it also offers investors a significant opportunity for growth — if you have the tactics and procedures to hedge against it effectively.
Despite the potential risks of market volatility, experienced investors like Jim Chanos have demonstrated that with effective investment strategies, it’s possible to not only navigate the ups and downs of the market but also capitalize on them. Chanos has recently demonstrated the effectiveness of this strategy through his Ursus short-only fund, which gained 18% in 2022. He achieved this by emphasizing the fund’s core strategy and implementing strong risk management tools, allowing him to take advantage of market volatility and improve his chances for success.
According to Jacob Sonenshine of Barron’s, “Stock market volatility is back, continuing a longer-term trend toward wilder swings in prices.” This increased volatility comes on the heels of the Silicon Valley Bank’s abrupt closure and the subsequent collapse of Signature Bank. These closings, in combination with the Federal Reserve’s increase in interest rates, have led the CBOE Volatility Index to rise from 17 to 25, indicating an increase in stock prices that are moving unpredictably throughout the market.
Even though this may feel risky, we stand with Sonenshine in his estimation that there is “good news” for investors who are willing and capable of riding out this storm to generate profits. Here’s how market volatility impacts securities and six key strategies you can use to build a resilient portfolio and generate the highest returns.
Why Market Volatility Impacts Securities
There are many factors that impact investment security volatility, including:
- Market factors: The value of investment securities is often affected by changes in broader market forces, including economic instability, changes in interest rates, inflation, and geopolitical events.
- Company-specific factors: Even if there is no fundamental change in the actual value of the security, investors may react to changes in management or rumors surrounding its performance and sustainability, which may cause the price of its securities to rise or fall.
- Liquidity: Securities that are less liquid or traded less frequently can be more volatile than those traded more often.
- Risk: Different types of securities have different levels of risk, and securities that are perceived to be riskier (such as stocks) may be more volatile than those that are perceived to be safe (such as bonds).
- Social sentiment: As we witnessed this past year with the rise and fall of meme stocks, sometimes shares of a company can have wild price movements simply due to heightened social sentiment. This social sentiment is usually based on activity online, particularly on social media platforms and, as we have seen, has nothing to do with underlying financial condition or outlook for the firm.
Accordingly, investors must learn to anticipate and account for these risks when making decisions.
Reasons Hedge Funds Love Market Volatility
Understanding why hedge funds are drawn to market volatility requires a closer look at the benefits that come with price fluctuations and how hedge funds are uniquely positioned to take advantage of them.
Hedge funds want price fluctuations and here’s why:
Hedge funds employ a wide range of investment strategies, such as long/short equity, event-driven, macro, and relative value. These strategies often allow funds to thrive in volatile markets, offering more opportunities to exploit mispricing and profit from price movements.
Price discrepancies across different markets or securities become more pronounced during volatile periods. Hedge funds can exploit these arbitrage opportunities by simultaneously buying undervalued securities and shorting overvalued ones, so that they ultimately profit from the convergence of prices.
Hedge fund managers can quickly adjust their positions and strategies to capitalize on market volatility through active management. Unlike passive investment vehicles, hedge funds are not constrained by a specific benchmark and can be more opportunistic in their investment approach.
Hedge funds are known for their ability to hedge against market risks. Volatility gives funds the opportunity to use various hedging techniques, including options, futures, and swaps, to protect the portfolio from significant losses while taking advantage of potential gains.
Hedge funds often use leverage to amplify their returns, which can be especially advantageous in volatile markets. By borrowing additional capital, hedge funds can increase their exposure to profitable opportunities that arise from market fluctuations.
Some hedge funds use market-neutral strategies, aiming to generate returns regardless of market direction. These strategies exploit the relative performance of different securities or asset classes, making them well-suited for volatile markets.
Volatility can lead to emotional decision making among investors, causing them to overreact to news or market sentiment. Hedge funds can capitalize on these behavioral biases by adopting contrarian strategies, such as buying undervalued assets that have been excessively sold off or shorting overvalued assets that have been the subject of irrational enthusiasm.
Making Market Volatility Work for Your Portfolio
Making volatility work in your favor necessitates a methodical approach to investment that may require you to use the following strategies:
Diversify Your Portfolio
One of the most effective ways to manage volatility is to reduce the impact of any single security or market event on your portfolio by diversifying it across asset classes, sectors, and geographies.
Focus on Long-Term Goals
Short-term market fluctuations can be unsettling, but focusing on long-term investment goals can help you see these changes with perspective and avoid making impulsive investment decisions.
Invest in Quality Companies
Investing in quality companies with strong fundamentals, such as a solid balance sheet, competitive advantages, and a strong management team, can help to reduce the impact of market volatility on your portfolio.
Use Dollar-Cost Averaging
Dollar-cost averaging involves investing a fixed amount of money at regular intervals, regardless of market conditions. Over time, this can help you smooth out the impact of market fluctuations.
Consider Alternative Investments
While alternative investments, such as real estate, commodities, or private equity, carry a certain amount of risk, they can provide diversification benefits and help you to protect your portfolio during volatile markets.
6 Key Strategies for Building a Resilient Portfolio
Here are six strategies to optimize your portfolio for resilience and growth.
Strategy 1: Streamline Transactions
Streamline processes so you can better manage all transactions. In a volatile market, your fund will necessarily handle more transactions. Ensure you have the procedures in place to make these transactions as seamless as possible.
Strategy 2: Check Positions and Daily Valuations
Ensure your positions and daily valuations are accurate. While you want to maintain a longer-term outlook, conduct daily check-ins on the real-time status of market positions and values to strengthen your portfolio.
Strategy 3: Analyze Positions Regularly
Analyze positions regularly to properly size them. To stay on top of an unpredictable market, you will need to increase the frequency with which you conduct analyses to ensure you’re sizing positions accurately.
Strategy 4: Think Fast
Respond quickly to news or events. If we’ve learned anything from the recent SVB collapse, it’s that being prepared is the best way to handle unexpected events. Put protocols in place prior to crises or conflicts and jump into action as soon as you learn of crises that may impact your fund.
Strategy 5: Monitor Short Interest
Keep tabs on short interest in securities and the rates prime brokers charge for stock lending to better understand the risks of holding such positions.
Strategy 6: Mitigate Risks
Identify areas in which your firm can decrease risks among your investments and make room for volatility with balanced and safe bets.
Implementing these key strategies will set your firm up for success in the face of a volatile market. Preparedness is essential in making these fluctuations work in your favor — for big returns.
The Bottom Line
While volatility presents a risk, it also offers investors a significant opportunity for growth — if you have the tactics and procedures to hedge against it effectively.
Volatility can be beneficial for hedge funds; however, it’s crucial to acknowledge the associated risks if a hedge fund manager’s predictions are incorrect or if they fail to adequately hedge a portfolio. By drawing on the strategies above, firms are better equipped to not only survive but thrive despite unpredictable market conditions.
If you’re looking for expert guidance and support, leverage Arootah Hedge Fund Advisory to improve your ability to handle the challenges of the market and optimize your performance. Book your free strategy call today to get started.