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.
