Skip navigation
Coronavirus
stock-market-volatility-chart.jpg solarseven/iStock/Getty Images Plus

The Growth of Volatility as an Asset Class

A growing number advisors are recognizing the long-term value of the systematic and dynamic inclusion of volatility assets in a portfolio.

For some time, advisors have been trying to harness the power of volatility assets in their clients’ portfolios, oftentimes with disappointing results.  Tempted by volatility’s large negative correlation to equities, advisors have still struggled to find a proper way to include volatility assets in a well-designed portfolio. 

Using a systematic, dynamic approach, volatility can still be used as a dedicated asset class in client portfolios. Evidence of the effectiveness of using volatility assets is growing through academic research that is being proven by performance of dynamic volatility assets during the current coronavirus (COVID-19) crisis. Before discussing the use of volatility as an asset class, let’s examine the past failures of static volatility.

The Failure of Static Volatility Exposure

Long Volatility: In the wake of the Great Financial Crisis (GFC), many investors purchased ETFs, ETNs, structured products, and “tail-risk” funds that provided static exposure to long volatility. Satisfying major recency bias held by shell-shocked advisors, some of these products caused irreparable harm to both portfolios and client psychology, as many of these products lost over 90% of their value in the years following the GFC.

Short Volatility: Significant research into the Volatility Risk Premium (VRP) led disaffected advisors and their clients to then begin to purchase ETFs, ETNs, and structured products that provided static exposure to short volatility.  These strategies worked great in client portfolios for limited time periods, until they didn’t: on February 5, 2018, VIX futures gained nearly 100% in a single day, more than three-times their previous largest single-day gain.  “Volmageddon,” as it is now known, destroyed many volatility portfolios, and further influenced client psychology against volatility assets.

These two periods of difficult returns in simple static volatility strategies gave many advisors pause when considering using volatility assets in their portfolios. Despite these setbacks in static volatility exposure, the concept of volatility as an asset class vs. just a strategy continues to grow, and the solution to past failures may lie in the dynamic management of volatility assets, applied in a systematic fashion.

Managing Volatility Assets for Client’s Long-Term Success

Dynamic Volatility: A growing body of research shows evidence that volatility can be used as a dedicated asset class in a well-constructed investment portfolio. However, advisors need to understand the role of this asset class before communicating with their clients.

Volatility assets have been added to the alternative investments syllabus of the Chartered Alternative Investment Association (CAIA), which discusses how the VIX exhibits “volatility clustering” and how it may be a “useful tool for forecasting.”  These characteristics contribute to the predictable nature of volatility assets, creating the potential for long-term value in dynamically rebalancing volatility assets based on their predictable nature.

Systematic Volatility: As any advisor knows, fear and greed are natural human emotions, but they can be very detrimental to investors.

One of the chief benefits of volatility assets may be their significant negative correlation to equity assets. In other words, volatility has the potential to produce significant gains when most portfolios need them most, in equity crises. However, that is precisely the time when fear can impact human discretion the most.

Another benefit of volatility assets may be their potential to increase returns in both bull and stagnant equity markets. However, years removed from the last crisis, advisors often succumb to greed and forget the need for risk mitigation on behalf of their clients, again impacting human discretion.

Most portfolio managers of volatility assets claim to be systematic, but they retain the ability to apply discretion when they see fit. However, this discretion often appears at the worst imaginable time: in a raging bull market, marked by low VIX levels and euphoria, and in a crisis, like the current period of unimaginable price movements and excruciating portfolio pain. 

For example, in the current coronavirus crisis, many people have become overnight infectious disease experts, as well as macro trading geniuses. Are these really the people clients want overriding the “systems” and managing the risk of volatility assets in their portfolios?

Therefore, volatility assets should be managed systematically, without human discretion, to ensure that risk management and alpha creation are not impacted by human emotion and bias.

Is Volatility an Asset Class?

A growing number of firms, advisors and their clients are now recognizing the long-term value of the systematic and dynamic inclusion of volatility assets in a portfolio. Mentioned above, CAIA now includes it in their alternative investments. In a 2012 Quantitative Research article on “The Volatility Risk Premium,” PIMCO argued that “the risk-return tradeoff for volatility strategies compares favorably to those of traditional investments such as equities and bonds and the strategies exhibit relatively low correlations to equity risk.”  And in 2015, Allianz wrote that “volatility is increasingly attracting investor focus as an alternative asset class.”

These groups make compelling cases. Simply put, portfolio managers can use systematic, dynamic volatility products to enhance portfolios over time. In the current crisis, many volatility products have thus far produced huge gains. 

That doesn’t sound much like a subset of any other asset class, most of which have been losing together in the risk-off environment, where many asset classes become highly correlated. It does, however, sound like its own asset class with an important role in a well-constructed portfolio.

Taylor Lukof is the Founder/CEO and Fund Manager of ABR Dynamic Funds, LLC, a New York-based asset management firm.

TAGS: ETFs
Hide comments

Comments

  • Allowed HTML tags: <em> <strong> <blockquote> <br> <p>

Plain text

  • No HTML tags allowed.
  • Web page addresses and e-mail addresses turn into links automatically.
  • Lines and paragraphs break automatically.
Publish