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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.

A similar situation arises with short volatility traders
but potentially to a greater degree because not only does a successful strategy
rely on accurate security selection but also having the ability to short the
appropriate securities. Arbitrage volatility investing seeks mispricing on a
relative basis and will not take a view on the direction of the markets but
will take a view on the relative value of the securities on offer and the
expected or “implied” volatility in the markets. This results in a market neutral
volatility strategy.

In strategies where there is a requirement to be able to
accurately forecast the direction of volatility, there is a chance that the
manager might get the direction wrong, and depending what securities he/she is
holding, there is a reasonable chance of underperformance in volatile market
situations. The volati lity lan
dscape Volatility investing is
relatively new to the institutional markets. It has until recently only been
undertaken by major banks in the US, and very successfully at that.

To date the banks have not seen the need to take the strategy to market due to
the available trading profits they were achieving within their own domains.
There are still relatively few volatility managers operating, and there are
some fund managers who are really directional equities traders rather than seeking
to focus on volatility trading as a strategy. Whilst acknowledging the various forms
of volatility strategies undertaken by a variety of managers, the strategy I would
like to focus on is market-neutral and non directional in nature.

Having previously
run a super fund with a strong risk management culture, I have formed the view
that when embarking on any new form of investing, it is most prudent to look
for sufficient controls which do not offer serious impediments to the
effectiveness of the investment process. Examp le of an Equity Index Volati lity Strategy •Inefficiencies exist within the equity index
option markets •Options have a finite term and will revert to true value at
expiry •Volatility Strategy trades equity index futures and options – eg.
S&P 500 options (where the underlying asset is the S&P 500 Index) are
traded on exchanges such as the Chicago
Board Options Exchange (CBOE) and Chicago Mercantile Exchange (CME)

• Trading
opportunities are assessed by comparing current implied volatility (VIX) with
historic volatility in anticipation of reversion to an expected value – VIX is
the ticker symbol for the CBOE Volatility Index (sometimes referred to as the “Fear
Index”) which is a popular measure of the implied or expected volatility of
S&P 500 Index options. •Analysis and assessment of volatility curves,
option prices and portfolio risk characteristics facilitates trading decisions
and execution of trades • Success of this approach relies on sophistication of
underlying risk management software and pricing models combined with experience
and skills of the derivative traders – there are relatively few participants
with the necessary skills to successfully trade these markets.

Where Volati lity Fits Super funds which have a traditional growth-oriented
asset allocation strategy would most likely place the allocation in the
alternative space under ‘hedge funds’. Some of the larger funds and
institutions would treat the exposure as part of the asset class in which the
volatility strategy is applied, ie. an international equity volatility strategy
would be included as part of the international equities allocation. There is a
smaller number of funds which have an “other” space in their asset allocation strategies
where they quarantine non-traditional and new investments and some funds would
place volatility investing in that space.

Those funds which employ alpha and
beta strategies might allocate volatility to either of those strategies depending
upon their requirements and how those portfolios are structured. There is also
an argument for considering volatility investing within a risk management
framework and one of Australia’s
large institutional investors is currently considering volatility investing from
that perspective. For superannuation funds which still have a defined benefit
component, an allocation to volatility with its consistent return profile can
be used to underpin the funding obligations of the sponsoring employer/s. Given
the potential alpha-generating characteristics of volatility, an allocation of
between 2 and 5 per cent is generally regarded as appropriate.

The degree of
risk associated with volatility investing is certainly no more than hedge fund
investing and depending upon the strategy selected, may be somewhat less risky.
For example, if a volatility strategy using only exchangetraded index
derivatives was employed, there would be less risk than using a strategy which
traded over the counter options because counterparty risk would be eliminated. Fad, Future Asset Class?

There is sufficient evidence available to show
that there is always volatility in the markets at sufficient levels to enable skilled
fund managers to reap consistent returns – even in low volatility periods, because
investors will always over and undershoot in their expectations and pay too
much or too little for assets. Many in the industry have experimented with
highly diversified portfolios in the mistaken belief that the greater the
degree of diversification, the greater the chance that these portfolios will be
able to withstand a severe market meltdown. What has persisted however, are
heightened levels of volatility and continued opportunities to capitalise on this
market phenomenon.



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