New strategy puts volatility forecast in driver's seat

Apr 29, 2012 @ 12:01 am

By Thao Hua

Target volatility asset allocation — which aims to maintain a constant level of volatility within an investment portfolio — is among the latest power tools institutions are using to control equity risk.

“Volatility tends to be mean-reverting over the medium term,” said Ric Thomas, senior managing director and head of alternative investments and absolute-return strategies at State Street Global Advisors.

As a result, it is possible to design asset allocation strategies that “target a certain level of volatility and dynamically allocate assets utilizing volatility forecasts, rather than, say, alpha forecasts.”

In turn, some consultants and managers are building models to predict volatility that can be applied at the portfolio level to improve risk-adjusted returns.

In its simplest form, equity exposures might fall in favor of bonds or cash during high-volatility periods and the reverse in relatively low-volatility times.

In addition to SSgA, other firms that have introduced target volatility asset allocation strategies during the past 18 months include J.P. Morgan Asset Management and Russell Investments. BlackRock Inc. and Pacific Investment Management Co. LLC use target volatility as a cornerstone within broader dynamic-asset-allocation strategies introduced within the past several years.

BlackRock's Market Advantage strategy doubled its assets under management in the past 18 months to $4.9 billion, and Pimco's global multiasset strategy has about $15 billion in assets under management,

Goldman Sachs Asset Management is considering a strategy that will delve into the volatility characteristics of individual stocks “to build dynamic portfolios that are better risk-adjusted at the individual-stock or [individual-]sector level,” said Etienne Comon, managing director and head of insurance strategy in Europe.

Compared with strategies that adjust asset mixes based largely on volatility levels at the macro level, the next generation of risk-controlled strategies will attempt to identify sources of unrewarded risk at the individual-security level.

“The two are complementary,” Mr. Comon said.


Client interest has risen globally, particularly among defined-benefit pension funds and insurance companies, following whipsaw periods of volatility last year, according to consultants and managers.

New regulations in Europe and the United States also have forced long-term investors to manage investment risk more carefully.

Critics, however, contend that targeting a stationary volatility level still can hurt investors during market inflection points, and relatively high portfolio turnover can be costly. They also argue that over the long haul, returns from a target volatility strategy might trail those of a constant asset allocation strategy.

Nevertheless, the idea that future returns are inversely related to volatility, which can be predicted and managed to a certain degree, is attracting some investors.

In the past 18 months, for example, Russell added about $4 billion in assets under advisement in strategies specifically designed to manage absolute volatility.

“There's a big shift in terms of how plan sponsors are defining risk,” said Michael Thomas, chief investment officer for the institutional business in the Americas at Russell. “During the last 10 years, our industry has developed an unhealthy obsession with tracking error, but managing tracking error isn't managing risk.”

Target volatility is best combined with other approaches, where “each [of the strategies] takes advantage of a different opportunity or exploits a different anomaly. Together, they all attempt to manage absolute risk,” Russell's Mr. Thomas said.

In a back-tested portfolio combining the three strategies and using data from the past 15 years, “what you find are returns similar to [the returns of] the Russell 1000 Index but with about 60% of the absolute volatility,” he said. “That's pretty darn interesting but comes with tracking error.”

So far, most of the target volatility asset allocation strategies focus on equity exposure, which is, “by far, the biggest contributor of [portfolio] volatility,” Russell's Mr. Thomas said.

The strategy could be “especially interesting” in Asia, where the use of derivatives to hedge portfolios may be more costly and difficult to execute, said Stoyan Stoyanov, head of research at EDHEC-Risk Institute-Asia.

He is the author of “Structured Equity Investment Strategies for Long-Term Asian Investors,” a paper published last year with financial support from Société Générale SA.

“Target volatility can be used to indirectly hedge fat-tail risks to a degree,” Mr. Stoyanov said.

“The focus is on achieving a more robust and stable volatility profile, as opposed to a fixed-asset-allocation mix,” said Michael Feser, managing director and head of quantitative research and portfolio management within the global multiasset group at J.P. Morgan Asset Management. “In this case, the objective is to keep the volatility relatively constant and adapt the asset mix to changes in the volatility level over time,” such as a 12-month horizon.

Another advantage is when combined with other hedging strategies, target volatility strategies can offset the cost of hedging and result in a more precise level of portfolio protection.

However, Mr. Stoyanov pointed to possible high portfolio turnover as a significant drawback, but one that can be mitigated in the implementation process, according to his paper.

Others are concerned about the assumed static level of volatility, which could range anywhere from 8% to 18% of the investment portfolio.

“You don't necessarily want constant volatility [within the investment portfolio] over time,” said Phil Page, a client manager at consultant Cardano Risk Management BV. “There are times when it's possible to benefit from higher volatility, and other times, lower volatility.”

Mr. Page and others point to last year, when volatility decreased in the first and second quarters, but spiked in the third quarter.

Depending on the particular model, equity exposures might have risen in the early part of the year as volatility waned, then suffered more losses in the third quarter.

By comparison, last year Cardano reduced equity exposures between May and July.

“We think a variable risk-based approach is more powerful,” Mr. Page said.

Cardano has about $9.4 billion in assets under advisement and another $3.1 billion in fiduciary assets under management.


At J.P. Morgan, managers are working to improve the timing and process by which risky assets are reduced or added.

“We want to make sure to sell those risky assets that give rise to most harmful volatility within the portfolio,” Mr. Feser said.

One way of reducing equity risk within a target volatility portfolio is to vary the overall amount that is held in stocks and bonds relative to the amount of cash, which is the “classic way of derisking,” he said.

“We would argue that there are better ways such as the use of price momentum as an information source to guide which asset to derisk and by how much,” Mr. Feser said.

Curtis Mewbourne, managing director at Pimco, said that the firm's global multiasset strategy does limit volatility to about 10% but also uses additional methods to control risk, including tail-risk hedging and portfolio diversification.

“When volatility increased above 10% of the portfolio in September and October of last year, the insurance kicked in and limited the downside,” said Mr. Mewbourne, co-portfolio manager of the Pimco Global Multi-Asset Fund, launched in 2008.

“This prevents [investors] from having to decide when to take money out and putting money back into the market. That's like trying to run away from a storm so it won't hit you, which is very difficult to do,” Mr. Mewbourne said.

During the same tumultuous period, the impact of derisking and subsequently re-risking left BlackRock's Market Advantage portfolio “virtually flat from an absolute-return perspective,” said Adam Ryan, director and portfolio manager at BlackRock.

“But the volatility of the portfolio was significantly reduced. That's a key measure of success for our clients,” Mr. Ryan said.

Although the derisking/re-risking strategy didn't add much value in terms of returns, it provided “a high degree of comfort when the world was looking like a grim place,” he said.

Thao Hua is a reporter for sister publication Pensions & Investments.


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