Everyone is a Volatility Trader

Imagine that you know absolutely nothing about the financial world but you are an expert on analysing data. You are given return streams for the last 100 years on all the different asset classes and investment strategies: equities, fixed income, real estate, commodities, hedge fund strategies, et cetera. As you examine the data from all these return streams and how they behave, you are fascinated by the realization that all assets fall into just two groups: those with a “short volatility profile” and those with a “long volatility profile”.

Assets with a “short volatility profile” tend to make steady gains for extended periods followed by sharp declines.  Argentinian sovereign debt provides a text-book example of this. Whilst having long periods of outperformance, Argentina has defaulted on their sovereign debt three times in the last 30 years with the most recent being in 2014. In addition to fixed income, other assets that fall into the category of short volatility include equities, real estate, and most other commodities.

“Long volatility profile” assets generally offer the opposite: flat to negative performance for an extended time followed by short bursts of extremely strong performance. This usually happens during highly volatile periods such as the Dot-Com Bubble, the Global Financial Crisis (“GFC”) and the European Debt Crisis. The most obvious long volatility strategy is buying portfolio insurance via long dated out-of-the-money put options.

Every investor is a volatility trader but few realize it. The problem we are seeing today is that investors are mistakenly thinking they are achieving diversification in their portfolios through selecting a broad range of short volatility assets. A common example of this is a “balanced” portfolio of 60% equities and 40% bonds which is considered by many to be well diversified; however it is all short volatility assets. It is true that this portfolio navigated the GFC well as interest rates fell to zero and bonds produced a hefty capital return. However, investors have become complacent due to the 30+ year bull market for bonds. It is unrealistic to continue to have such expectations for future returns and has led to investors failing to recognise the imperative of holding assets with a long volatility portfolio.

To illustrate simply the effectiveness of diversifying a portfolio across volatility, compare a short volatility portfolio (S&P 500) to an equal-weighted portfolio of short and long volatility assets (S&P 500 and CBOE Eurekahedge Long Volatility Hedge Fund Index). This index started in December 2004 and is not the perfect proxy for long volatility strategies, but proves the point nonetheless. 

Despite volatility declining to historic lows over the past few years, the equal-weighted portfolio has kept up with equities with considerably less risk.

Prudent investors would be wise to truly diversify across assets with both long and short volatility return profiles. With record-high markets, record-high global debt, and record-low market volatility, it is an excellent time to add long volatility assets to one’s portfolio. 

By Dan Jenkins, Business Analyst at NZAM