In Strategies to survive a bear market – Part I we looked at the benefits of long/short equity strategies to ride out market turbulence. In the second part of this series, we focus on volatility and the benefits this emerging asset class may bring to an investment portfolio, particularly in tough market conditions.
Nearly two months into 2016, stock market screens remain a sea of red and headlines continue to herald a global bear market. However, it hasn’t all been bad news – markets have rebounded (often to fall again) and some stocks have defied the trend.
One word has been consistently used – volatility.
According to Simon Ho, CEO of volatility experts Triple3 Partners, the year ahead will be one of ‘episodic’ volatility, rather than wildly veering highs and lows; an environment that will create opportunities for astute investors.
Ho said the type of market volatility we have seen over the past month is what we can expect to see for the rest of this year.
“The past month is a portent of what is to come on the markets this year – bouts of volatility. It will not be calamitous as it was in 2008. It hasn’t been like that and it won’t be like that. Instead we will see small markets movements of a few per cent frequently, rather than any large GFC-like one day falls.”
What is volatility?
Volatility represents a statistical measure of the dispersion of returns for a given security or market index.
The word volatility is often used interchangeably with words associated with risk. Although it is typically portrayed as a bad thing, volatility can provide diversification benefits to an investment portfolio.
A higher volatility means that a security’s value can potentially be spread out over a larger range of values; therefore the price of the security can change dramatically over a short time period in either direction. A lower volatility means that a security’s value does not fluctuate significantly, but may change in value at a steady pace over a period of time.
The creation of the CBOE Volatility Index (VIX) was the first step in making volatility an investable asset class. The VIX is considered a benchmark barometer of market volatility and investor sentiment, and measures expected volatility on the S&P500 Index over the next 30 days. A high VIX reading indicates that investors expect that the market will move sharply, either up or down.
Investors can’t invest directly in the VIX; volatility can only be accessed by using options and volatility derivatives.
What are the benefits of investing in volatility?
Modern portfolio theory tell us that every asset added to a portfolio should fulfil one of two purposes:
- Provide alpha to the portfolio
- Reduce portfolio risk
Portfolio diversification has long been considered a key risk management strategy, as diverse asset classes should perform differently at various times of the economic cycle.
However, during severe market corrections, traditional relationships between assets tend to break down. The volatility of risky assets tend to rise as there is greater uncertainty and correlations across assets can increase dramatically, meaning that portfolio diversification does not always work to manage risk.
Although many alternative investments, such as hedge funds, have been held up as negatively correlated with equities, Figure one illustrates that this is not always the case.
Using the S&P/ASX200 Index (ASX200) as a base, hedge funds (as represented by the Credit Suisse Hedge Fund Index) are positively correlated with equities and become more so when this equity index drops. Australian investors using hedge funds to diversify their portfolio and hedge equity market risk would not have a satisfactory outcome.
An investment in volatility can provide diversification because volatility is generally negatively correlated to equities – and most other asset classes.
A number of academic studies have shown volatility to be causally negatively correlated to equities, as represented by the S&P500 Index; it is inversely related to equity index prices, especially when there are large moves.
This causal relationship, illustrated by figure two, enables an investor to generate negative correlation to equities. It has what’s called a ‘convex’ payoff profile – the more the S&P500 Index falls, the harder and faster the VIX tends to rise.
Periods of financial stress are often accompanied by steep declines in the sharemarket. As a result, option prices – and the VIX Index – tend to rise. The greater the fear, the higher the VIX; this explains why the VIX has become colloquially referred to as the “fear index”.
The importance of assets with a negative correlation to equities
Australians love equities. Whether direct investments, through managed funds, ETFs or superannuation, we have high levels of equity investment. According to the OECD, the average Australian super portfolio has a 50% allocation to equities (source: Pension Markets in Focus, OECD Report, 2015) with many having a much higher exposure.
At a time when equity markets are looking shaky, investors need to be mindful of sequencing risk; this is the risk that the order and timing of investments is unfavourable.
For example, a retiree may have made significant contributions to their superannuation during the past few years and be preparing for retirement; a period of negative equity returns can have a significant impact on their retirement savings.
As shown in Figure three, a loss of 20% requires a gain of 25% to recoup that loss; the greater the loss, the greater the gain required to get back to the starting point.
Investing in volatility
There are two ways retail investors can access volatility – via a managed fund that invests in VIX-based derivatives, or a managed fund with a volatility overlay.
The managed fund
A volatility managed fund will typically invest in cash and VIX-based derivatives, either futures or options. With low correlation to other asset classes, an investment in a volatility fund can be used to enhance returns and manage risk, potentially providing an additional source of alpha to a portfolio.
Volatility overlay
A volatility overlay is an investment strategy that uses derivatives instruments to manage the risk of a significant market downturn while allowing investors to retain an exposure to growth assets, therefore helping to manage both sequencing risk and longevity risk.
It is a systematic program of applying a portfolio of derivatives over a broad-based equity exposure with the aim to reduce draw-downs and in some cases, add alpha over time.
There are a number of overlay strategies used by fund managers; these include futures-based strategies, tail risk hedging, covered call writing and dynamic options strategies. For more detail on volatility strategies, refer to the article Survival strategies for turbulent markets.
There are numerous volatility overlay options available to investors. It’s important to understand the characteristics of each, how it works with each investor’s objectives and how it will impact the return profile of the investor’s portfolio.
Click here to read CPD: Strategies to survive a bear market – Part I
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