The whole is greater than the sum of its parts
Unigestion’s equity proposition is built around our risk-focused investment approach, which has helped deliver strong risk-adjusted returns for over 20 years. In fact, we have the longest track record in the industry of managing equities in this way. We apply this same successful philosophy within our volatility strategies, drawing also on more than 30 years of hedge fund investing experience to deliver a compelling investment proposition for today’s challenging market environment.
Traditionally, under normal market conditions, portfolio diversification has been an effective risk management tool. However, in recent years, we have seen correlations between traditional asset classes, such as bonds and equities, increase markedly meaning they no longer offer the usual benefits of diversification in a balanced portfolio. Alternative equity strategies, such as volatility investing, can help overcome such problems.
What is volatility investing?
Volatility investing involves the use of options. The development of the Black-Scholes model in the 1970s led to a boom in options trading and provided mathematical legitimacy to options markets around the world. The Black-Scholes formula has only one parameter that cannot be directly observed in the market – volatility. However, this parameter can be derived from the price of an option, and is called implied volatility. Therefore, the price of an option can be expressed either in terms of premium in dollars or, in terms of (implied) volatility, in percentage terms.
The implied volatility is a normalised price of an option, while the realised volatility is a measure of the cost of underwriting an option. An investor who buys or sells options with the objective of having an exposure to the implied volatility will hedge the underlying risk. While hedging this risk, an option seller will systematically sell when the underlying falls and buy when it rises. Realised volatility is therefore a good proxy for the cost of buying high and selling low.
By selling options, an investor collects the premium and assumes the risk of price moves. In theory, the risks are unlimited, similar to a short call – however, they can be limited by buying a hedge portfolio.
Why invest in volatility?
- Increased bond and equity correlations are challenging the traditional asset allocation model
- Volatility offers diversification thanks to low correlations to both bonds and equities
- In today’s low interest rate environment, volatility offers an attractive source of alternative income
Different types of volatility strategies
Practitioners usually distinguish between four volatility strategy styles
- 1. Short volatility. Discover more
- 2. Long volatility. Discover more
- 3. Tail-risk volatility. Discover more
- 4. Relative value volatility. Discover more
EXPECTED BEHAVIOUR OF VOLATILITY STRATEGIES
|Short Volatility||Long Volatility||Tail Hedge||Relative Value|
|Correlation to Equity||Low||Negative||Very negative||Zero to low|
|Success rate||Very high||Low||Very Low||High|
|Positive returns||Small||Large||Very Large||Medium|
|Negative returns||Large||Small||Very Small||Medium|
|Source: Eurekahedge, Bloomberg|
- Net seller of options
- Low but positive correlation to equity (around 60%)
- High probability of small positive returns
- Small probability of large negative returns
- Faster time to recovery than equity exposure
- Positive expected return (prefer collecting premia)
- Net buyer of options (constantly long volatility)
- Negative correlation to equity (around – 30%)
- High probability of small negative returns
- Small probability of large positive returns
- Negative expected return (prefer paying premia)
- Seek to achieve large gains during periods of extreme market stress
- High negative correlation to equity during market stress
- Very high probability of small negative returns
- Very small probability of very high positive returns
- Negative expected return / only positive during market crashes
Relative value volatility
- Largest category, made up of very different strategies, including: statistical volatility arbitrage, dispersion and absolute return
- These funds can switch between long, short and neutral views on volatility
- Uncorrelated with equity
- High probability of positive return
- Low probability of negative return
The key to volatility investing is to understand how each strategy behaves, how they interact and how risk is priced depending on the volatility regime. At Unigestion, we believe that the best approach is to combine three different styles in particular:
- Carry: sell optionality for a premium and bear the risk
- Hedge: buy optionality to reduce drawdowns
- Relative Value: opportunistic positioning to take advantage of price dislocations
There are a number of advantages of taking such an approach:
- Risk diversification: Hedge and Carry are negatively correlated and Relative Value is uncorrelated to both styles
- Leverage: managing both Carry, Hedge and Relative Value in the same strategy allows us to control the effective leverage of the total portfolio at any time.
- Strategic allocation: each of the three styles has phases when they perform well and when they do not – we believe it is particularly difficult to add value by timing these periods and therefore do not attempt it.
- Dynamic allocation: While market timing is a difficult exercise, we believe that we can add value by dynamically allocating across the volatility surface to find the most expensive point to sell and the cheapest to buy.
Trying to achieve risk diversification with distinct managers can lead to base risk and leverage risk. By combining styles, we can solve these issues as we manage both the carry and the hedge and are therefore able to control both the base risk and the net exposure.
Base risk: Many volatility funds consist of a single strategy. Therefore, combining two highly focused but different managers can create a significant base risk. Diversification is therefore often suboptimal unless the investor has the capacity to allocate to a sufficient number of sub-strategies.
Leverage risk: The second challenge is associated with the effective exposure. Sophisticated volatility strategies usually have varying exposure depending on the price of volatility, the volatility curve and their view. It is therefore almost impossible to size the positions on the funds effectively and net exposure can easily switch from net long to net short without adjusting the weights in the portfolio.
Taking advantage of price dislocations: When attempting to exploit price dislocations, it is essential to understand the behavior of each opportunistic trade and how it fits in with the overall relative value portfolio. Some trades will be positively correlated to equities, some negatively and some will simply be a reversion to the mean type of trade. Overall, relative value tend to have a very low beta to the market.
It is important to have many uncorrelated trades in the portfolio knowing that dislocation can go on for a long time and can always go further. As dislocation opportunities are occasional by nature, the relative value portfolio will not have a constant market exposure – this is why it is important to complement it with a carry and hedge strategy.
UNIGESTION’S VOLATILITY PROPOSITION
SUMMARY OF VOLATILITY STRATEGIES BY STYLES
|STRATEGIC ALLOCATION||DYNAMIC ALLOCATION||OPPORTUNISTIC ALLOCATION|
Building an “all-weather” base
Quickly adapting to different market conditions
Investing in specific short term opportunities
A full market cycle (1-3 years)
Within market cycle (1-6 months)
Short-term (1 to 12 months)
Systemetic + Fundamental