Using volatility strategies to ride out the storm

With volatility expected to remain high over coming months, strategies which profit from market swings or try to hedge portfolios from those wild market movements are very much in demand.

Volatility is described by some as a fourth asset class, in addition to equities, bonds and alternative investments. It is often referred to as the “hidden” asset class, although in reality it is a just a measure. A popular indicator of implied volatility is the VIX index. Often referred to as the “fear gauge” of Wall Street, the index measures the market's expectations of the short-term volatility of the S&P 500 index.

The VSTOXX, the benchmark of volatility in Europe, measures the implied volatility of the DJ Euro STOXX 50 index. As neither index is directly investable, investors generally seek exposure via futures contracts.

Volatility strategies can be a source of return or a source of protection, explains Fabian Dori, portfolio manager at 1741 Asset Management AG. In arbitrage strategies, for example, traders will be short or long volatility depending on whether they forecast volatility will fall or increase.

“In the current environment, we would recommend to invest in volatility as a source of protection. When used as a return driver, as in many hedge fund strategies, there is no guarantee that the added diversification will offer any additional protection to the overall returns of the strategy,” he says. “In our strategies, we use exchange traded volatility instruments, such as futures, which reduces counterparty risk.”

Investors seeking protection for their equity investments are always long volatility. This position would normally generate returns when equity markets decrease, as there is a negative correlation between volatility and equity markets. Stockmarket crashes are accompanied by spikes in volatility.

As a source of protection, investing in volatility can be an insurance against losses on the equity portfolio. Nobody can predict when the next market crash will happen, so the question is whether investors prefer a fixed insurance, ie a passive exposure to volatility, or a flexible insurance, ie a strategy that actively manages its long exposure to volatility, explains Mr Dori.

A passive exposure will provide investors with some form of protection against a market fall, but can be expensive. In an active strategy, the manager dynamically manages the long only exposure to volatility to reduce overall cost. He tries to estimate how much insurance he needs. He will lower the amount of money invested into volatility, when he expects it to decrease, in order to minimise losses. He will increase his long positions, if he expects it to increase. This strategy will not always cover the investor fully against volatility but is less expensive.

“Being long volatility is similar to having insurance against losses on your equity position and, as with any insurance, there is a premium to be paid. When building a strategy, one of the biggest challenges is to minimise the insurance premium,” says Mr Dori.

A multitude of investment instruments that trade volatility are available and range from hedge funds and structured products to exchange traded products.

With the launch of exchange traded notes (ETNs) into the European market in 2010, investors now have a cost efficient and transparent route to access European volatility, states Nathan Bance, director in UK investor solutions at Barclays Capital. “ETNs have simplified the market and offer a straightforward way for investors to trade volatility as they can be bought and sold like a stock.”

They also free investors from the need to buy and sell futures themselves, which can be complex, he says. However, given it is a debt instrument, investors do have counterparty risk.

Direct investment into volatility, especially on the long side, can be risky, says Arnaud de Servigny, global head of discretionary portfolio management at Deutsche Bank PWM. “Exchange traded products (ETP) that are long or short volatility are often not closely following the underlying. So there can be either some stickiness or overreaction of the ETP versus the underlying index,” he says.

“During the crisis, volatility indices did not work as well as in the past, as volatility did not react immediately to the market evolution, which made it hard to have it as long run investment,” adds Mr de Servigny.

ETFs (exchange traded funds) can be used to gain exposure to equity index volatility, but the investor must be able to trade them, as they are not a buy and hold instrument as their value decays over time, says Dan Briggs, chief investment officer at Fleming Family & Partners.

Volatility indices tend to work within general bands so the secret is selling volatility by writing options when implied volatility is high. Equally, if volatility is very low, it is very cheap to buy protection by buying a volatility ETF. On the basis that volatility rarely falls through certain lower bands, the downside risk is limited but the upside is quite good. In the event the market becomes more volatile, which usually signifies stress and price declines, the investor has an instrument that will have gone up in value, says Mr Briggs.

In periods of stress, the risk is higher. The volatility index for the S&P 500, the VIX, used to trade between around 15 and 35 up to the Lehman collapse, when it spiked up to 70-80 , and many investors found themselves in a difficult situation. “It is a dangerous strategy to be betting on levels of volatility in stressed periods, because there is the possibility that volatility spikes downwards, ie the downside risk is higher than the upside in the event volatility protection is bought at very elevated levels,” he explains.

Fund strategies that benefit from high volatility include CTAs, whose return profile, not correlated to risk assets, make them particularly useful when correlation between assets tends to rise.

“For a lot of the time, CTA funds are not particularly interesting because they need to find some momentum in volatility in order to do well, but we tend to add to CTA strategies at a time that the market is quite stressed such as now,” explains Mr Briggs, stating his preference for Ucits III hedge funds.

Strategies on listed or OTC options are also an indirect way to benefit from periods of high volatility. “If you identify stocks that you would be happy to own but you have some serious concerns about whether they might fall further, you can agree to buy that portfolio of stocks at a strike price, below the current level of market, and you are paid quite handsomely in terms of receiving a premium for that,” he says.

“The disadvantage of this strategy is that the market may fall by more than you anticipated,” says Mr Briggs. “Then you may have to buy a portfolio at a price above where you could in the cash market.”

But an investor with longer term investment horizons, such as a family office, has less of a need to hedge for short-term volatility, and can afford to look through some drawdowns, if there is confidence the returns will be there in the medium term. Also, in this very low interest rate environment, selling a put on specific stocks is very attractive as it gives income in the form of a premium.

“What we would never do would be to sell a ‘put’ on an index where you are agreeing to buy a large basket of stocks, some of which you would not necessarily want to own and where some of them might be very stressed.”

When selling ‘puts’ on individual stocks rather than on an index you get “more bang for your buck”, but the risk is higher, says Mr Briggs.

Structured products are suited to play active strategies or single-stock volatility trades but the ones currently available can be quite risky in the event of a very sharp fall, adds Mr Briggs. In order to make the returns attractive, they often don’t give the protection the investor thinks they are getting because of contingent ‘knock in’ features.

“We don’t tend to use structured products as they only protect you in a normal scenario, but we are much more concerned about high-impact, low-probability scenarios, or ‘black swans’, which are much more common than the statistical framework would lead you to believe,” he explains.

In the current environment of high uncertainty and moderate expected returns, investors can take advantages of extreme variations in market sentiment, believes Mourtaza Asad-Syed, global head of tactical and thematic investments, at Société Générale Private Banking. “Investors’ mood is very versatile, and this creates opportunities, as implied volatility reaches high levels, while realised volatility remains lower.”

While macro risks are still looming, volatility spikes offer opportunities to sell volatility, he says. “Investors convinced like us by an equity market ‘stuck in trading range’, especially in Europe, could sell to upside volatility and buy cheap protection when the market had a good run, and sell downside volatility when it dropped severely.”

As a rule of thumb, when the US market trades 6 per cent above its 50-day moving average and volatility drops below 25 per cent (VIX), investors are too optimistic and it is time to sell some upside in exchange for downside protection. When the market falls 6 per cent in under a week and volatility is above 35 per cent, then investors are too scared and it is time to sell downside volatility, explains Mr Asad-Syed.

Hedging volatility is very useful in managing short-term correlations within a portfolio. “For instance, building asymmetric payoff strategies using options, or structured products with protection barriers or capital guarantees, changes the correlation an instrument will have with others, independently of usual market correlations,” he claims.

Volatility becomes an opportunity if the manager can be dynamic in the way they expose their capital to the market and have the ability to raise cash or to protect capital.

“Having your capital fully exposed to the market beta is too risky in this complex environment, equally it is too risky to have a net long position of zero,” says Michele Patri, fund manager of AllianceBernstein’s European Flexible fund.

“To deal with volatility you want to be investing in products that can move their exposure to the equity market flexibly from zero to 100,” he says. As they do not have a benchmark to beat, flexible managers are free from the pressure to be fully invested all the time.

The European equity market is dominated by a very strong polarisation of valuations, where good and defensive stocks trade at extremely high valuations and some cyclical companies have very low valuations. The strategy is to be out of those stocks that are burnt out in terms of valuations as well as out of those very high quality but too expensive stocks and to short stocks with debt and refinancing needs, says Mr Patri.

“You need to take the emotional bias out, you need to be objective and very disciplined,” he says, explaining how quantitative models should support qualitative analysis.

Another way to deal with volatility is to invest in low-volatility stocks which can provide downside protection for equity portfolios. The low-volatility anomaly exploits the tendency for lower-risk stocks to have better risk-adjusted returns than higher-risk stocks over time, explains Pim van Vliet, portfolio manager, Robeco Low Volatility Equities.

Investors in search for safer alternatives in the equity space should consider less risky stocks. These tend to outperform during down markets and in moderately rising markets are also expected to show gains. But they tend to lag during sharp market upturns, as investors bid up the price of more risky stocks. “That’s the price you pay to profit from the low-volatility anomaly,” says Mr van Vliet.

But over the long term, a strategy that is able to consistently lose less money in down markets, while seeing positive returns during moderate up markets, more than makes up for the lag during sharp bull markets.

If the focus is on absolute returns rather than relative returns, ie capital preservation and growth rather than beating the benchmark, then low vol equities become very attractive, he says.

“Low volatility equities are a great asset to have in the core of investors’ portfolios, because they give you access to the equity premium but with lower risk,” says Mr van Vliet, adding that unexpectedly there are many low-vol stocks in emerging markets too.

Higher volatility breeds higher correlation of returns across asset classes, and a multi-asset class approach is often used to deliver portfolio diversification. But today it is necessary to recognise we are in a bipolar world, characterised by risk-on and risk-off scenarios, says Emanuele Ravano, managing director, Pimco in London. It is necessary to diversify the portfolio not just based on the asset class but on the risk that the asset class incorporates.

“If you look at assets from a risk factor approach, it is quite complex to understand how they change and how they interact at a portfolio level,” he says. It is vital that managers adjust their views and act accordingly, for example by removing exposure to asset classes when necessary. Commodities have been traditionally uncorrelated to other asset classes but this has changed.

“Early in the second quarter last year we reduced commodity exposure as they were pricing in a lot of geopolitical and growth risk.” Two years ago European debt was perceived a risk free asset, now it is a credit risk, says Mr Ravano. “Dynamic change in the risk underlying asset classes requires active management.”

Also, it is crucial to ensure portfolios against extreme events, he says, and this is best done in a multi-asset portfolio context. “You have got to be disciplined to spend in a systematic way to protect yourself against these unforeseen left-tail events, because we are in an environment with self-reinforcing negative feedback loops.”

Dynamic portfolio management

Asymmetric pay-offs using derivatives are useful to hedge volatility, as long as volatility stays quite low, says Deutsche’s Mr de Servigny. “During Q2 and Q3 last year, our buzzword was to build convexity in portfolios – we wanted to protect portfolios from downside risk, using assets that tend to react positively to stress market conditions, typically long duration bonds, or ‘put’ options that give downside protection.”

When volatility gets higher, which has been the case since Q4, this hedging strategy gets more expensive, but it was implemented on centrally managed portfolios to mitigate downside risk. “What clients expect from us is wealth preservation,” he says.

“This is quite challenging to achieve in an environment where risk assets are under pressure and where so called safe assets are very expensive. We are in the business of dynamic portfolio management, where we need to be able to react, to mitigate risk for clients, and take the opportunities where they exist, we can’t just buy and hold and wait and see. Clients are really expecting us to manage downside risks,” adds Mr de Servigny .

Taking short-term or tactical investment decisions in an environment driven by fundamentals is easier than in a risk on/risk off environment, when financial markets are dominated by the policy making process, he says. “Some government actions will have a positive impact on assets, so for example an accommodating monetary policy will have a positive effect on currencies. But it all depends on the degree of conviction you have, so the lower the conviction, the lower the tactical weighting.”

The uncertainty around the eurozone requires caution but, in the long run, large, well managed global corporations able to harness themselves to global growth levels in the region of three per cent, will offer good opportunities, says Mr de Servigny. “We are very cautious at the moment, but we are certainly aware that over the next months, maybe as the situation deteriorates, there could be a relatively good entry point for taking on more risk assets.”