Volatility Control is a simple investment approach which has been advocated by banks and asset managers for some time, but which has so far failed to gain significant traction among UK pension schemes. We believe this could be about to change and that Volatility Control may have a role to play within the mainstream approach to pension fund equity asset management.
Volatility Control as a concept is the management of an equity allocation through continual rebalancing between equity and cash holdings. At any given point in time, the volatility of the portfolio measured on a trailing basis should remain roughly constant: if the trailing volatility of the equity holding goes up (usually associated with an equity market fall), then the allocation to equity will decrease in favour of cash.
The underlying idea is to keep the overall amount of risk (as measured by volatility) coming from the total equity plus cash portfolio roughly constant. This is in contrast to the conventional approach of making a fixed allocation in monetary terms to equities, the risk of which will vary substantially through time.

Despite the simplicity of the concept, a study of returns since 1998 shows that, across equity markets and time periods, the strategy has delivered equity-like returns with substantially lower volatility. The results are robust to changes in the rebalancing frequency and precise calculation of volatility measure.

What has changed?

In September 2009 S&P launched a set of indices available on Bloomberg which follows the performance of various volatility controlled portfolios; a number of indices are available, and some of them are illustrated below:

Ticker (1) Market
Volatility target Rebalancing Start date of Bloomberg data Volatility Last 10 yrs (2) Return  %p.a. Last 10yrs Market volatility 10 yrs (2) Market return % p.a. 10 yrs
SPXT10UT S&P500 10% Daily July 1998 9.7% 5.8% 21.3% 4.8%
SPXT12DT S&P500 12% Daily July 1998 11.7% 6.4% 21.3% 4.8%
SPXT12UT S&P500 12% Monthly July 1998 11.6% 5.2% 21.3% 4.8%
SPEU10EN S&P Euro 350 10% Daily July 1998 10.5% 5.1% 20.2% 5.5%
SPRA10UT S&P Asia 50 10% Daily Dec 1998 9.7% 8.6% 23.4% 12.1%
SPGS10UT GSCI 10% Daily July 1999 9.8% 4.6% 25.6% 2.7%

Source: Bloomberg, Redington

(1) replacing T with E at the end of the ticker name gives the excess returns series relative to the underlying equity market, as opposed to the total return index
(2) Volatility measured as the annualised standard deviation of daily log returns
In the July/August issue of Insurance Risk, a particular article entitled “The Volatility Challenge” highlighted the potential Solvency II capital savings that could be realised as a result of  investing in equities via this volatility control framework as opposed to via “straight” equity. The potential savings were substantial. The article cites examples of Fund Managers running mandates for insurers targeting a capital charge of 15-20%, compared to the Standard Formula capital charge of c40% for developed market equity.
Volatility Control is not CPPI

Although the two may seem similar, the Volatility Control approach is different to the ill-fated Constant Proportion Portfolio Insurance (“CPPI”), which has been popular at various points in the past but has come out with a less than favourable reputation. The main difference between the two is that CPPI looks to replicate the delta of an option, which can involve a much sharper deleveraging out of equity in the case of a market fall. The Volatility Control approach, by contrast rebalances as the trailing measure of equity volatility increases.

Although Volatility Control is a new concept for many pension fund trustees, it is an established approach that has been applied with success within hedge funds and other asset managers for some time. Indeed, there is a broad category of “Diversified Beta” funds that broadly use a Volatility Control methodology to control their allocation to a broad set of market risk factors such that a constant amount of risk comes from each factor.

As we look to the past, we see many of the major shifts in pension funds’ activities stemming from successful approaches used within the traditional banking or asset management space; it may be that Volatility Control offers pension funds a new approach to managing assets that helps to be aware of and react to changes in risk, volatility and reward.

[Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice. Click here for full disclaimer]