Dan Mikulskis provides an introduction to volatility control and explains how it might fit into a pension fund setting
Volatility control as a concept is the management of assets through continual rebalancing between a risky asset holding - often, but not always, equity - and cash holdings. At any given point in time, the volatility* of the portfolio measured on a trailing basis should remain roughly constant: if the trailing volatility of the equity holding goes up (usually associated with an equity market fall), then the allocation to equity will decrease in favour of cash.
Despite the simplicity of the volatility control concept, a study of returns since 1998 shows that, across equity markets and time periods, the strategy has delivered equity-like returns with substantially lower volatility. In September 2009, Standard & Poor's (S&P) launched a set of indices available on Bloomberg that follow the performance of various volatility-controlled portfolios (see Table 1).
In the July/August 2012 issue of Insurance Risk, an article entitled 'The Volatility Challenge' highlighted the Solvency II capital savings that could be realised as a result of investing in equities via this volatility control framework as opposed to via 'straight' equity.
The potential savings were substantial. The article cited fund managers running mandates for insurers targeting a capital charge in the region of 15% to 20%, compared with the standard formula capital charge of circa 40% for developed-market equity.
Volatility control is not CPPI
Although the two may seem similar, the volatility control approach differs from the ill-fated constant proportion portfolio insurance (CPPI), which has been popular at various points in the past but has significant drawbacks. The main difference between the two is that CPPI looks to replicate the delta of an option, which can involve a much sharper deleveraging out of equity in the case of a market fall.
Also, if there were a significant loss of original capital under CPPI, then the system would de-lever and never regain full exposure. With volatility control, there is a natural pull to being fully invested, whatever the level of capital remaining.
Figure 1 below plots the performance and volatility of an equity index and two volatility-controlled products on that index. We can observe that:
> Both the daily-rebalanced and monthly-rebalanced indices achieve their objectives of remaining close to their volatility target. Both indices did exceed their target volatility by more than 1% on around 20% of days, and by more than 3% on less than 10% of days.
> The volatility-controlled indices were close to 100% invested in equities during the period 2003 to 2007, with similar returns to equities.
> The volatility-controlled indices de-levered as the crisis escalated in 2008, taking equity exposure to around 20% at the end of 2008. This can be seen in the peak-to-trough fall in the volatility indices of some 15%, compared with around a 50% fall in the S&P 500.
> In the rebounding equity market between 2009 and 2011, initially, both volatility-controlled indices lagged the sharp bounce in the underlying index as they took time to re-expose themselves to equities.
> The daily rebalanced index increased its exposure to the equity markets more rapidly than the monthly rebalanced index and therefore outperformed the monthly rebalanced index in return over the whole period.
What are the advantages of volatility control?
Given the volatility that markets have experienced over the past 10 years, volatility control strategies can look attractive in return terms when compared with a conventional investment.
In many ways, this is misleading, as it creates the impression that these strategies should be expected to outperform conventional allocations over the long term: they should not. Instead, we can expect better risk-adjusted returns from this strategy compared with a conventional allocation.
Volatility control also fits well within the risk budgeting framework typically employed by pension schemes and their advisers. In this framework, some of a scheme's overall risk budget is allocated to equities based either implicitly or explicitly on an equity volatility assumption in the region of 16% per annum to 20% per annum.
As we can see from Figure 1 below, the actual volatility of equities is both well above and below this range most of the time. Perhaps then it would be sensible to invest in a way that delivered more constant volatility - a volatility control approach delivers this.
What are the risks inherent in volatility control?
Volatility control protects investors during periods where the volatility of the risky asset rises above the target. However, it is also possible that the value of the risky asset could decline materially over a prolonged period of time but without volatility increasing. If this were the case, volatility control would offer no advantages against a conventional allocation.
Recent history in equity markets suggests that significant falls are associated with increased volatility, but this will not be the case for all assets over all time periods.
Parameters to be considered when designing a mandate
Volatility control should be seen as a high-level approach to investing rather than as a specific product and, as such, a wide range of implementations is feasible. The primary requirement is simply that the underlying asset is sufficiently liquid to allow relatively frequent rebalancing at costs that are not punitive.
However, a number of parameters do need to be defined in the process of setting a volatility control mandate, and the S&P indices give a good starting point for setting these parameters and for benchmarking a strategy.
New application for an established approach
Although volatility control is a new concept for many pension fund trustees, it is an established approach that has been applied with success within hedge funds and by other asset managers for some time. It also appears to be gaining traction in the insurance industry in light of possible capital savings under Solvency II.
As we look to the past, we see many of the major shifts in pension funds' activities stemming from successful approaches used within the traditional banking or asset management space. It may be that volatility control offers pension funds a new approach to managing assets that helps them to better track and manage the risk of their portfolio.
* The merits and challenges of the many possible measures of an asset's volatility are well beyond the scope of this article. However, we believe the broad properties of a volatility control strategy are robust to the precise method chosen.