In Case of Fire, Use Volatility

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Published on March 15, 2019

| 6 min read

David Schofield, President, International Division

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Institutional clients are increasingly seeking equity protection-type strategies to cushion portfolio value from the effects of market volatility. Conventional wisdom presumes the path to seeking equity portfolio protection comes exclusively from the use of derivative strategies. These tend to be accompanied with added complexity as we grapple with the choices available to protect portfolio value. The analogy of purchasing fire insurance is often used to simplify the understanding for considering derivatives. The most common choices for portfolio insurance are: either purchasing a straight protective-put, a put-spread, or a zero-cost collar.

The protective put choice is analogous to accessing unlimited fire insurance on one’s house. Meanwhile, a put-spread involves the purchase of a put option, which is simultaneously financed by the sale of a put option that is extremely out-of-the-money. Choosing this is akin to purchasing limited fire protection on one’s house; should your house burn down, an excess has to be paid before collecting your insurance.

Finally, a zero-cost collar is akin to accessing free unlimited fire insurance. Upfront payment is not required. However, in the case of fire, a full pay-out will take place after you pay an excess, and if the value of your house had increased prior to the fire, the insurer has the right to some portion of your home’s equity.

Regardless of which volatility mitigating strategy is selected, each of the aforementioned derivative strategies have a cost associated which can rise rapidly and proportionate to fluctuating market dynamics, the desired level of timing precision, and the willingness to roll the strategy forward, all of which can pose a drag on performance.

Rethinking Volatility

While option strategies can be customized, the experience often disappoints where costs can be higher than anticipated and the level of protection less than what was ideally desired. At Intech®, we believe there is an alternative to protecting equity value: volatility. Volatility is the fuel to our investment process.

Investors often think of volatility as having a negative connotation, something which should be controlled, or avoided. However, when viewed correctly, volatility can serve as an important resource, strengthening portfolio resiliency by signalling when to reduce risk and when to embrace it.

We believe incorporating a volatility input into the investment process is like including the use of fire-retardant materials to construct a better house, and therefore build in superior allocation of capital to deliver better outcomes.

Link to Drawdowns

We demonstrate below how volatility is linked to drawdowns, which can serve as an effective sign of potential risk of loss, and explain how volatility can serve as an adapting signal.

Volatility and absolute loss have historically exhibited a clear link. Figure 1 shows rolling 130-day (approximately six months) annualized standard deviations for the MSCI World Index between 1992 and 2017, as well as corresponding drawdowns measured by percentage loss. It’s evident that volatility is indeed volatile, varying from very low levels to sudden spikes. The patterns form an almost mirror image of market drawdowns. Volatility spikes have been associated with recoveries, but more frequently connected to declines. This suggests that volatility may serve as an effective signal if a market is potentially entering a period of heightened risk of loss.

Applying these insights may also help implement an effective variable beta management solution in order to better protect on the downside in poor market conditions without curtailing upside participation in strong periods.

 

Figure 1 - Relationship Between Realized Volatility and Drawdowns

A Measurement of Risk

Based on this strong historical relationship between volatility and drawdowns, we test whether volatility on its own offers an effective adapting signal. The premise is simple: as market volatility increases, one should decrease portfolio risk and vice versa. Doing this consistently across full market cycles should lead to stronger portfolio outcomes. In Figure 2, a simple volatility-driven strategy shows significant improvement in returns versus the benchmark over full market cycles by missing most of the downside and participating in some of the upside. Across the entire 25-year period, the simple strategy captures an annualized excess return of 70 basis points with 46% less volatility. This represents a Sharpe ratio more than double that of the index.

 

Figure 2 - Testing a Simple Volatility-Driven Model

Optimizing Variable Beta

These volatility insights can work together to help optimize a variable beta portfolio. By creating a more dynamic, adaptive strategy that also draws from the more resilient nature of individual security volatilities, investors can potentially capture additional upside to even further expand the full-cycle performance advantage.

One can design such a strategy using relative volatility by carefully evaluating how stock prices move (i.e., volatility) and their evolving performance relationships relative to one another (i.e., correlations). Such a strategy would be designed to deliver repeatable, excess returns over a full cycle with significantly less risk through active portfolio rebalancing and beta exposure management.

A more sophisticated, variable beta strategy would also estimate volatility on multiple time scales and dynamically adapt beta based on the current risk environment. Given that risk regimes are typically longer term, these features can help inform the optimal rate of adaptation to maximize risk-adjusted returns.

Conclusion

Volatility is an unavoidable threat to long-term equity returns. To mitigate this risk, the inclusion of protective strategies can be expensive and pose a cost to performance.

When it comes to effective portfolio management, balancing volatility risk mitigation and generating long-term returns is a false choice. Understanding the clear historical link between volatility and drawdowns can provide a valuable rebalancing signal; one that our research shows can be applied to enhance potential overall performance and Sharpe ratios. Moreover, this model contains no return forecast, lessening the uncertainty of when it makes sense to reduce portfolio risk and when to embrace it.

Understanding and actively applying stock price volatilities and correlations can both help to reduce risk exposure when it matters most while offering a reliable and ever-present source of alpha. The alternative consideration to buying fire insurance is using the fire retardant properties of volatility to construct a better portfolio. We believe this approach delivers better outcomes through strengthened risk-adjusted performance across full market cycles.

Is Volatility a Friend or a Foe? Learn more about how volatility can help strengthen portfolio resilience. Download Now

 

The information expressed herein is subject to change based on market and other conditions. The views presented are for general informational purposes only and are not intended as investment advice, as an offer or solicitation of an offer to sell or buy, or as an endorsement, recommendation, or sponsorship of any company, security, advisory service, or fund nor do they purport to address the financial objectives or specific investment needs of any individual reader, investor, or organization. This information should not be used as the sole basis for investment decisions. All content is presented by the date(s) published or indicated only, and may be superseded by subsequent market events or other reasons. Past performance is no guarantee of future results. Investing involves risk, including possible loss of principal and fluctuation of value.