Many asset classes have experienced high (by historical standards) returns in recent years at comparatively low levels of volatility
. Some equity indices for example have recently made new all-time highs. However plenty of risks remain. Investors and pension funds need to generate returns from their assets, but worry about what a big fall in their value could do to their position.
Given this backdrop, it’s no surprise that strategies and approaches that look to control risk by curbing exposures at the most risky times are gaining popularity. One approach that we’ve been recommending and implementing for our clients is equity volatility control, we discussed the idea in a blog back in September 2012
Since then we’ve encountered many sensible questions as we’ve talked to trustees and worked through the implementation, some of these were captured in a previous blog
Below I capture another seven questions frequently asked of equity volatility control today.
Q1. I’m trustee of a pension scheme with a 20 year duration of liabilities, how will equity volatility control help me?
A traditional approach to building a pension fund portfolio has been to take on significant exposure to equities and therefore equity risk in the expectation that this risk will be rewarded, and these returns will contribute to closing the deficit. Equity portfolios will experience falls in value from time to time, and while some losses on an equity portfolio can be recovered within a few months, larger losses (such as those experienced in 2008) can threaten the long-term funding target of the scheme. Equity volatility control mitigates these losses by reducing equity exposure in periods of higher volatility (and increasing exposure in lower volatility periods) in order to reduce risk whilst maintaining returns.
Q2. I’m the sponsoring employer of a pension scheme, why would implementing equity volatility control benefit me?
Big loss in equities will materially worsen scheme funding position, if actuarial valuation date follows a large loss, this can result in a higher contribution level being paid by the employer and can impact the disclosed balance sheet of the employer, potentially threatening its financial position. The reduction of downside risk means the employer paying stable contributions over the long term, avoiding money pouring into a pensions ‘black hole’.
Q3. I understand volatility control involves trading every day, aren’t the transaction costs huge?
No – for one thing, if the volatility of markets remains close to your volatility limits (your “risk budget”), you will not have to trade much to change your market exposure. However, the key point is that when you do trade, it is with derivatives – commonly equity futures and equity total return swaps. These give you exposure without having to buy the physical assets, removing the hassle of buying and selling on a daily basis as well as the expensive transaction costs. It is cheap and liquid, and we would expect transaction costs of no more than 15-20bps per year. This is in line with other non-market-cap weighted indices.
Q4. If the strategy is so effective, why isn’t it more widely used?
This strategy is widely used in Europe – specifically in Germany, Switzerland and the Netherlands. It is also used in the US VA (Variable Annuity) market.
Q5. This sounds like a short term trading strategy, shouldn’t we be concerned with the long term?
Investing in equities is a long-term strategy; volatility control manages periods of portfolio volatility in the shorter term (which can be associated with bad outcomes).
Q6. But volatility won’t always predict crashes, so why should I use volatility as the indicator?
Volatility won’t always predict crashes, but generally speaking periods of higher volatility are associated with bad outcomes and it can benefit investors to avoid them. Volatility is a good measure of “stress” in the markets, and today’s volatility tends to be closely related to tomorrow’s. Periods of high volatility are generally associated with higher risk and bad outcomes for equity investors, against which the strategy is designed to protect. Admittedly it is not perfect, since equity exposure may not have been reduced if a crash occurs without a preceding fall in volatility, but in the majority of cases it provides protection against market movements.
Q7. If buy and hold equities deliver a similar result over the longer term, why not just do that?
The key difference is that there is no downside risk protection if you buy and hold equities. Having volatility control strategy in place, you will take a smoother path with more stable investment return and less variability of funding level.
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.