Since we last discussed the idea in the December 2012 issue of Outline, we have seen significant developments of the usage of volatility control in constructing benchmarks for equity allocations.
Over the course of 2013, we have:
Worked with banks and clients to develop the principles behind a volatility controlled index, based on the MSCI World and Emerging indices;
Developed a particular volatility calculation methodology, based on exponentially weighted measures (which give declining weight to older observations);
Supervised the execution and implementation on behalf of one of our largest clients, who moved their entire equity portfolio to a volatility controlled benchmark with a put option in place, ensuring that their equity portfolio cannot decline in value by more than 10% over a one year period.
By implementing an equity benchmark which incorporates volatility control, schemes can expect to experience a lower, and more consistent, level of risk within their equity portfolios by adjusting the exposure in response to changes in market conditions. The level of expected return remains similar to a passive equity allocation.
By also implementing a put option the scheme gains the peace-of-mind that their equity portfolio cannot fall in value by more than a certain amount over a 1-year period. In our example, by working to find the most accurate volatility measure, we reduced the cost of a 90% put option to just 0.88% per annum.
Figure 1 : Risk and return of scheme's equity portfolio
By putting a floor on the value of the equity portfolio, the put option means that the scheme is much less likely to experience a “Black Swan” event that could throw it off its flight plan.
The scheme moved the benchmark for its equity portfolio to a volatility controlled index with a volatility level of 10%. The index was based on the MSCI World Developed and Emerging indices as the underlyings, with a daily mechanism for adjusting the exposures according to changes in the level of volatility.
The exposure was gained through executing a Total Return Swap with several investment banks, in addition a put option with a strike level of 90% was bought on the same underlying indices. The put option was substantially cheaper than a similar option on a conventionally managed equity benchmark.
Table 1 : Current cost of protecting an equity portfolio
Source: Bloomberg, Investment Banks; Calculations: Redington
The performance of the index benchmark can be seen on Bloomberg ticker MLEI10VW Index
The execution and ongoing management of the Total Return Swap is carried out by the scheme’s LDI manager, allowing the scheme to make very efficient use of the collateral pool at its disposal. The swap and option are for a one year time period. The trade was split between three investment banks with all three providing daily valuation of the option.
Please note that all opinions expressed in this blog are the author’s own and do not constitute financial legal or investment advice. Click here for full disclaimer.