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Drawing on his previous experience as a super fund executive, and his current role running distribution for (among other things) a global volatility fund, DENIS CARROLL addressed a recent CIE Conference on the potential role for volatility-based products in future portfolio construction. Here’s an abridged version of his talk.

There are many definitions of volatility and it has a variety of meanings depending on the particular context. In simple terms, volatility is the price of risk. However, the definition which I believe best fits volatility in investment parlance is: the measure of the variability of returns over a chosen time period. It is this movement in prices which can be measured which affords the opportunity to identify mispricing (which normally happens with investing) and to make buy/sell decisions based on the investor’s/manager’s judgement on the true price of the security.

You buy volatility if you think it is cheap and sell when you think it is expensive. This forms the basis of volatility investing. The key features which make volatility attractive as an investment are that volatility markets are inefficient, liquid, deep, sophisticated, uncorrelated with other asset classes, able to perform in up and down markets, and act as another form of diversification. There are a number of forms of volatility investing; for example, variance contracts are a form of volatility investing.

Volatility investing may take place in any asset class where there are tradeable securities although the most common is equities, either countryspecific, regional or international. Either index options or individual securities may be traded. The size and depth of the market is an important factor in the selection decision. Long volatility investing means that the manager has taken a view on the volatility in the markets and has purchased securities on the expectation that volatility will increase over an expected time period.

The manager will purchase securities which he/she believes do not adequately reflect the true price of the volatility in the market on the expectation it will rise. If the manager is successful in predicting the direction of volatility then substantial gains can be made on those securities in which he/she is invested. However if the market does not behave in accordance with the manager’s expectations, then substantial losses can result. Short volatility investing means that the manager will sell securities that are over-priced on the expectation that volatility will collapse and he/she can gain by “shorting” the market.

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