In 2009, U.S. banking regulators subjected 19 of America's largest and most important banks (the "too-big-to-fail" ones) to so-called stress tests in order to understand how well each bank's capital reserves would meet different challenging economic scenarios. Regardless of the arguments for and against the execution of that test, the concept is interesting outside of the banking industry context. For instance, which strategies are best able to deflect volatility in client portfolios when real market stress shows up?

Unfortunately for most investors, the past few weeks have provided ample opportunity for analysts to gauge risk mitigation (and lack thereof). Consider Figure 1. Volatility, as measured by the Chicago Board Options Exchange Market Volatility (VIX) index, has increased sharply in recent weeks amid deep concerns about Eurozone banks and the fiscal health of governments in much of the developed world.

Anxiety really took off following Standard & Poor's decision to downgrade long-term U.S. government debt from AAA to AA+. For at least the following month, the VIX remained well above the 30.0 level; at least twice the level we saw most of the year. In fact, in the month following the downgrade the S&P 500 index had 10 days with swings of 2.5% or more in either direction. It had only three the prior year.

These wild swings provide a good laboratory to dissect the performance of risk-mitigating strategies. As seen in Figure 2, those chaotic conditions affected alternative strategies to varying degrees. Here, we've charted the performance of a hypothetical $10,000 investment in the average performance in each of six common alternative or risk-aware classifications alongside the Mixed-Asset Target Allocation Growth and S&P 500 Index Funds groups. The most obvious choice for the perfect volatility hedge is Dedicated Short Bias Funds. They've performed as advertised, rising quickly (they are frequently leveraged) as equity markets tanked. But, timing the ownership of these—particularly the leveraged versions-can be hazardous as their choppy values prove. In fact, in this example, if you did not own a short-bias fund before the S&P downgrade virtually all of your upside performance was lost.

Both the Commodities-Precious Metals and the Precious Metals Funds groups produced plus-side performance, but the Commodities classification (which is entirely exchange-traded funds that buy futures contracts) was a better overall hedge, as the mutual funds often sank when mining stocks dropped in tandem with general market conditions. Significantly, the correlation between these two groups is 0.49 (on a scale where 1.0 is perfectly positively correlated and zero is no correlation), meaning less than 25% of their variation is related. Seen from this angle, Precious Metals Funds are not a good substitute for their ETF cousins.

We also note that Equity Market Neutral Funds and Absolute Return Funds achieved nearly the same results. During the tumult each declined modestly by about $200 to $300 on our hypothetical $10,000 investment. Given their similar performance (and high correlation of 0.94), it's completely understandable if investors treat these two strategies as substitutes for each other.

Although Absolute Return Funds are sometimes associated with Long/Short Equity Funds, the Long/Short group bore little resemblance to Absolute Return as it slumped virtually lockstep with the S&P 500 Index Funds. The short portion provided some cushion but broadly speaking, managers in this category were caught flat-footed. If the justification for this strategy is the diversification benefit, it should confer a much lower correlation with a popular core holding such as Mixed-Asset Target Allocation Growth Funds than the 0.99 figure it realized.

Controlling volatility is, like insurance, something that seems too expensive until you really need it. Given the severity of the issues besetting the world's economic and political leadership, it also seems doubtful that this volatility will soon pass. But treating all alternative strategies as equivalents or substitutes will not solve for much of the downside protection investors need. As recent data suggests, some are good hedges, some are good diversifiers, and some do very little.


Jeff Tjornehoj is head of Lipper Americas Research,
focusing on the United States and Canada. He is a regular
contributor to Lipper's Fund Flows and Closed-End Funds reports.