The Active Manager’s Conundrum

Below-average market volatility is typically associated with above-average returns. Should an active manager prefer to operate in a low volatility environment or a high volatility environment? What factors should influence this decision?

Introduction

Should an active manager prefer to operate in a low volatility environment or a high volatility environment?  What factors should influence this decision? 

At first glance, the choice seems fairly easy.  The paper reminds us that volatility and returns are inversely related.  Rising volatility typically penalizes results and vice versa.

The paper provides exhibits that make the manager’s choice look obvious: if volatility is high, returns tend to be negative; if volatility is low, average returns are substantially positive.  Positive returns mean that the manager’s clients are making money, which they usually appreciate, and that the manager’s fees (if asset-based) are also rising.  Attracting new assets is easier in a rising market, whereas “investors do not reward outperformance in down markets with higher subsequent flows.”

Lower volatility means that managers and clients alike enjoy a smoother return path with fewer surprises.  The manager should obviously wish for low volatility, both for its own sake and because of its connection to higher returns.  What could go wrong?