Reduce volatility in your portfolio

Volatility in markets is always a key input for traders and investors alike. But one way to reduce volatility in a portfolio is to consider long/short (or "pairs") strategies and look for outperformance from one asset against another.

An idea I think could work well both from a fundamental and momentum perspective is being long Japanese equities and short emerging markets. One can express this view through exchange traded funds (ETFs) by buying the WisdomTree Japan Currency Hedged fund (ASX: DXJ) while going short the iShares MSCI Emerging Markets ETF (EEM). It is important to have the same US dollar consideration on both legs. For example, if DXJ is priced at $55 and EEM at $34 and I want to use $2000 on each side, I would buy 36 units in DXJ and 59 units in EEM.

I would initially keep position sizing small but potentially add to it once the ratio (DXJ price/EEM price) moved above 1.6413 times, the all-time high. As part of my risk management, if the ratio fell below 1.4231 times (October 14 low) I would exit the trade as I would effectively be proved wrong.

The fact the trend is mature doesn't concern me; in fact, I see it as a positive. I also sit in the camp that the US dollar is likely to continue to appreciate over the medium term and this should put further pressure on emerging markets. Remember that many of them have huge US dollar liabilities and this debt burden increases as the US dollar appreciates.

The Bank of Japan is likely to increase its balance sheet to 90% of GDP in 2016 and this liquidity, added with compelling earnings growth and valuation, makes Japan relatively attractive. In fact, a strong US dollar could benefit Japan given the positive correlation between the Nikkei and the US dollar/yen.

Chris Weston is Chief Market Stragegist, IG

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