Editorial –The Meaning of Cash

Wouter Klijn, Director of Content at the Investment Innovation Institute [i3]

Long or Short Volatility?

The Repeatability of Crisis Alpha

If most diversified, multi-asset portfolios are short volatility, should institutional investors build in an allocation to long-volatility strategies for defensiveness?

Ever since bond yields hit record lows, institutional investors have been searching for an alternative to this defensive asset to provide some level of protection to their portfolios.

But this search has not been easy.

Some have looked for factor strategies and hedge funds, while others have looked for unlisted assets or bond proxies such as real estate. But nearly every asset class or alternative strategy has its own issues at different parts of the cycle.

The reality is all of these asset classes ultimately rely on one key ingredient: economic growth. The traditional 60/40 diversified portfolio benefits from growth in economic activity and low or declining volatility.

Another way to say this is that all of these portfolios are short volatility.

Perhaps the answer to the question of how to build a hedge against such a portfolio is to simply go long volatility.

There is some evidence such an approach might actually work.

In a recent [i3] roundtable discussion, some asset owners reported that their long-volatility holdings produced as much as 160 per cent returns during the difficult months of March and April this year, when the COVID-19 pandemic caused turmoil in global equity markets.

Nicolas Rabener, Managing Director of FactorResearch, explains in an article for the CFA Institute how this might work.

Taking a simple 60/40 portfolio, consisting of United States equity and bond indices, he adds in a 20 per cent allocation to a long-volatility index, in this case the CBOE Eurekahedge Long Volatility Hedge Fund Index.

Then he tracks the performance, volatility and maximum drawdowns over the period from 2004 to 2020.

The results are striking.

Although the allocation to long-volatility strategies slightly reduced the compound annual growth rate from 7.0 per cent to 6.8 per cent over the period, the volatility came down too, from 7.9 per cent to 6.1 per cent.

But even more impressive is that the maximum drawdown rates almost halved.

Where the 60/40 portfolio experienced a maximum drawdown of 30.1 per cent during this 16-year period, the portfolio with a 20 per cent allocation to long volatility had a maximum drawdown of ‘only’ 16.3 per cent.

Problem solved then? If only it was that easy.

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There are two key issues with allocating to long-volatility strategies. The first is that they are quite painful to hold in bull markets. The second problem is one of repeatability. Although these strategies worked well during previous crises, it can be quite difficult to rebuild them post-crisis.

There are two key issues with allocating to long-volatility strategies. The first is that they are quite painful to hold in bull markets. During our roundtable, one asset owner said it was experiencing negative annual returns of 10 to 15 per cent in these strategies in the years before the coronavirus crisis, resulting in a significant drag on returns.

Not every investment committee or board will tolerate such performance in periods of prolonged bull markets.

The second problem is one of repeatability. Although these strategies worked well during previous crises, it can be quite difficult to rebuild them post-crisis.

After experiencing equity market drawdowns of 30 to 40 per cent during March and April, stock markets recovered quickly when central banks and governments ramped up monetary and fiscal stimuli.

But the prices of long-volatility equity strategies, especially puts, have remained high. So much so that it would be prohibitively expensive to put a similar risk mitigation strategy in place as before COVID-19.

Of course, investors can adopt similar long-volatility strategies in other asset classes such as foreign exchange or commodities, but these will not provide the same level of protection as equity-based long-volatility strategies do.

Back to the drawing board then? Well, no, but implementing a long-volatility strategy might not be a straightforward solution in all market conditions.

But then again, who said investing is easy?

Wouter

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[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.