Volatility : An asset class to make a portfolio more robust to crises

Investors, especially those of long-term maturity, should take advantage, to make their portfolios less vulnerable to episodes of market stress...

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After two years of extreme price fluctuations of financial assets, many investors today have taken the measure of loss that could result in exposure to risky asset classes, including the equity markets. For many investors, especially those with the constraints of short-term solvency proved disadvantageous, the subprime crisis has created serious consequences. Not only assets deemed risky have performed poorly during the crisis, but in addition they had a tendency to see their volatility increasing and lose all power of diversification. This phenomenon, having been particularly severe in 2008 and 2009, is coming back the same way for all episodes of stress. Since the devastating episode of the subprime crisis, a fertile reflection has been initiated on how we could try to protect a portfolio against adverse consequences of the crisis, or at least limit the losses.

But, what assets should we include in a portfolio to protect against extreme losses that inevitably occur during crises ? In truth, among the traditional asset classes, there is little that government bonds. They have the phenomena of flight to quality (investors reallocating massive investment assets considered risky to the "safe havens") and their performances are excellent: 11% for U.S. bonds from September 2008 to March 2009 for example. But these investments are not without drawbacks. even though they performed well in the long run in the last 20 years, largely because of the long movement of disinflation that has occurred since the 80’s, the expected returns on government bonds are likely to be much more lower in the future for many reasons related to the level of historically low interest rates, and risk of resurgent inflation.

An alternative solution is emerging as a particularly simple and far more attractive to "strengthen" a portfolio regarding crises, it is the volatility. this solution may at first seem strange to say. Volatility is in fact traditionally considered a risk indicator, measuring the standard deviation of asset returns. How then consider it as an asset class and how to invest ? The recent development in financial markets for standardized products on volatility now gives access to a new range of strategies to bet on future volatility, and thus acquire a structural exposure to volatility; In a recent research paper just published in the Journal of Portfolio Management[1], we show how investors, especially those who manage a portfolio with long term maturities, should take advantage, to make their portfolios less vulnerable to stress episodes in the markets.

Two complementary approaches in the volatility can be addressed simultaneously: pure exposure to the implied volatility (that is anticipated) of an underlying asset, and exposure to volatility risk premium, defined as the difference between the implied volatility of an underlying and realized volatility at maturity.

Adding a pure exposure to the implied volatility of an equity portfolio (via the purchase of "futures" contracts on the VIX index for example) is particularly interesting for diversification (stocks and volatility are negatively correlated to -60%), and especially, can benefit from excellent protection when equity markets fall. This proved particularly beneficial during the subprime crisis: while the U.S. equity markets were down 37% from September 2008 to March 2009, the strategy outlined in the volatility sported for its outstanding performance by 57%. Investors can thus avoid the extremes risks of their portfolio, making it much less risky than a traditional portfolio. This protection is also very inexpensive. Over the past 20 years, our backtests show that this volatility strategy would have offered long-term return similar to that of government bonds, with a much better protection during crises.

The second type of exposure to volatility through investment in the volatility risk premium, is much more risky. Similar to the sale of an insurance premium[2], this strategy generates very attractive returns, but at the cost of risk of loss during crises significantly higher than that of traditional asset classes. Considered alone, this strategy may appear too risky for traditional investors. But instilled at very low measures in a portfolio, and combined with the strategy of pure exposure to volatility, which mainly covers it during crises, it takes a lot of sense. The joint exposure to these two strategies can then provide better portfolio returns, with a risk comparable to that of a traditional portfolio. Located on the border between traditional approach to markets and hedge fund management, strategic investment on volatility as an asset class presents many opportunities for investors. Considered a long-term investment, volatility allows to build more efficient portfolio than the traditional stocks/bonds mix.

Marie Briere May 2010

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[1] “Volatility Exposure for Strategic Asset Allocation”, M. Brière, A. Burgues, O. Signori, The Journal of Portfolio Management, Spring 2010.

[2] This exposure is the result of a short position on a variance swap, the investor receives the synthetic implied volatility of a underlying, the strike of variance, and pays the realized volatility of the underlying asset over the lifetime of the swap.




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