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.
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?
|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|
|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%|
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
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.