Russell advises cautious approach to volatility investing

  • Russell has released a research paper to raise awareness and encourage discussion
  • Proper education required to understand payoffs and risks

An exposure to volatility can offer investors the opportunity to enhance performance, either as an investment in its own right or as a hedging instrument, according to Russell Investments.

Russell cites an exposure to volatility as a relatively new and technical investment area, and has released a new research paper to provide education and encourage discussion on the topic. The paper details the features of volatility as an investment and the role it can play in a portfolio, with the aim of educating investors on its benefits and risks.

Volatility as an investment allows investors, in most cases, to benefit from the difference between the future volatility of an asset class and the implied volatility of options based on that asset. There are a number of strategies and products that enable investors to gain such an exposure.

The use of volatility products is currently not widespread and as such there could be a first mover advantage, but Russell has found that the main barrier so far has been education, according to Chris Inman, Senior Analyst, Russell Investments.

“We’re not recommending that all investors rush into volatility products, especially if they’re inexperienced and not prepared for the potential downside. But we believe that given the right education and knowledge of risks, volatility products will become more popular with institutional investors in particular,” Mr Inman said.

Different approaches

There are a variety of instruments that provide a ‘pure’ exposure to volatility such as VIX futures and variance swaps. Using such derivative instruments, there are two main strategies for investing in volatility; one is to go long, which in most cases provides downside protection in the event of heightened volatility which tends to coincide with negative equity returns. The second strategy is shorting, which effectively involves selling insurance to investors who are willing to pay a premium to protect themselves against the risk of volatility and poor returns.

Mr. Inman warns that a short volatility investor needs to be comfortable with the risk that should an event materialise which causes the market to be more volatile than anticipated, they will lose money. ‘”After all, there is a reason why investors pay premiums to protect against volatility and poor returns in the first place,” he adds.

Due to the nature of payoffs, an exposure to volatility is most suited to institutions (including superannuation funds) as it is important to have the funding to be able to sustain potential losses. Individual traders and retail investors should approach volatility with caution and be well prepared for the risks.

Current trading of volatility is most commonly linked to US indices such as the S&P 500. It is not yet a widely used strategy in the Australian market.

“The key to acceptance in all markets is to ensure investors know about the uses of volatility products and don’t dismiss it simply because it can initially be difficult to understand. While it’s not for everyone, there is scope for more institutions to get involved and find volatility a useful addition to their portfolios,” Mr Inman added.

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