Methodology

We develop a comparative analysis of different strategies in a framework that allows for stochastic volatility, reflecting the reality of Asian equity markets. We compare four different strategies combined in two pairs – a fixed-mix and target-volatility strategy; and a classic option-based portfolio insurance (OBPI) strategy and a target-volatility strategy with an OBPI feature implementing a capital guarantee. The target volatility is achieved through state-dependent rebalancing between the market index and the risk-free asset.

Fixed-mix strategies are traditional investment approaches. Typical examples include the 60/40, 50/50 or 40/60 fixed mix between stocks and fixed income. The investor’s risk-aversion level will translate into a higher or lower proportion of stocks. Fixed-mix strategies can be viewed as target-volatility strategies in a constant volatility economy and, thus, comparing them to true target-volatility strategies measures the consequences of trying to control volatility through a traditional fixed-mix in a stochastic volatility environment. The target-volatility strategy is compared both in terms of utility loss and the pay-off’s distributional properties at the investment horizon.

Another traditional strategy that is tested is a long-only investment with a capital guarantee feature implemented through a call option written on the underlying. The option provides protection on the downside while the performance of the underlying asset provides upside potential. It is compared to a target- volatility strategy with a capital guarantee feature added. This gives the value-add from the improved upside potential of the target volatility underlying within the OBPI structure. The improved upside potential results from dynamic rebalancing which, apart from controlling volatility, increases the probability of obtaining positive returns and also reduces extreme risk by making the downside of the asset return distribution at the investment horizon more Gaussianlike. We consider a capital guarantee of 90 per cent but the level is a matter of choice; our results are general.

Results

Our first important finding is that the return distribution of the fixedmix at the investment horizon in the stochastic volatility economy under consideration is significantly negatively skewed and has excess kurtosis. These properties imply higher downside risk and unattractive upside potential.

In contrast, the target-volatility strategy has positive skewness and almost no excess kurtosis, which means both the downside and upside of the return distribution are improved.

This conclusion is confirmed by comparing the OBPI strategies where the downside risk is completely removed because of the capital guarantee and the upside potential depends entirely on the features of the underlying asset.