The paper, Brave New World: Assessing Volatility Strategies for Portfolio Construction, looks at the range of asset protection strategies for volatile markets that are based on the VIX volatility index and assesses their suitability for Australian investors. 

Interest is growing in investment strategies which seek to reduce the impact of market volatility on investment returns or actually exploit that volatility to make money for investors. This is being driven by heightened market volatility in the wake of the global financial crisis, the failure of traditional volatility protection strategies to protect investors and structural changes to asset markets that are increasing volatility, like high frequency trading. 

A number of new managed funds have been launched since 2008 that seek to address these needs. 

The paper warns that simply being “long volatility” is highly likely to be a loss-making strategy because of the high cost of buying and holding VIX futures. 

Using an actively managed volatility strategy with a bias to absolute returns is a better approach to mitigating losses in falling share markets and can produce higher returns overall for equities investors. 

Simple volatility strategies tend to succeed in reducing losses when the share market falls sharply, but also reduce potential returns when markets are rising. 

Active management of volatility can overcome this problem by exploiting mispricing and relative value opportunities in the VIX options market. 

“Volatility strategies that systematically exploit the alpha inherent in VIX options markets, or those that access VIX futures exposure when holding costs are not prohibitively expensive, can be combined with absolute shares funds to produce superior returns when compared with long-only equity market exposure,” the paper concludes.  

The research tested a number of different investment portfolios, which combined varying amounts of volatility strategies and actively managed absolute return and hedge fund strategies. 

It found that a portfolio which uses a specific combination of long-volatility strategies, volatility-arbitrage strategies and absolute return strategies can produce superior returns to other approaches, including a long-only equities strategy, over the long term.

6 August 2012

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