Investing in volatility:

Transcription

1 Investing in volatility: a new frontier for traditional portfolio diversification Intended for professional clients as defined by the MiFID directive AN EXPERTISE OF

2 Quantitative Research White Papers # 3 SEEYOND Volatility management and structured product investment division of Natixis Asset Management Over the past decade, financial markets have been shaped by the growing interconnexion between asset classes, the increasing frequency and magnitude of shocks, as well as the obvious exhaustion of market trends. Many investors believe that to generate performance in the medium to long term, relying on traditional asset management alone is no longer enough. To meet these new challenges and to offer investments that combine performance generation with risk reduction, Seeyond implements investment strategies that go beyond conventional active management. In order to turn uncertainty into opportunity, Seeyond develops a complete range of funds in 3 areas of expertise: - Structured Beta & Guarantee - Smart Beta - Flexible Beta & Volatility The portfolio management team is daily supported by a quantitative research platform. With 32 employees, Seeyond has 15.1 billion in assets under management as of 30/09/2014 (Source: Natixis AM). 2

3 # 3 Quantitative Research White Papers CONTENTS Introduction 5 Dissecting the environment helps better understand the limits 6 of traditional diversification Pushing the boundaries of traditional portfolio diversification 9 Conclusion 12 3

4 Quantitative Research White Papers # 3 SUMMARY Diversification is a cornerstone of investors' mindset. Recent developments in macro economic policies, broadly masterminded by the Fed, had shed light on the limits of diversification across equities & bonds. Our analysis shows that including equity volatility as an additional asset class can improve diversification by creating a source of risk mitigation. We show also that equity volatility allocation has to be actively managed in order to effectively improve diversification. 4

5 # 3 Quantitative Research White Papers INTRODUCTION The debate around the diversification benefits of combining traditional asset classes, including stocks, bonds and cash has been pushed to the forefront in light of the recent market experience. The tapering announcement by the FED in June 2013 had effectively a negative impact on both stock and bond markets. This co-movement pushed up correlations, and outlined the issue related to the stability of correlations, and therefore cast doubts upon the potential diversification benefits. By considering the relationship between stocks and bonds over the past 25 years an observer can arrive at the conclusion that correlations are time varying (graph 1). History can certainly help identify some of the variables at work. However the ability to extrapolate future assumptions has its limits. Nevertheless identifying the different states of nature in which asset class returns vary in relation to one another provides useful information on how correlations react depending on economic conditions. This will be the starting point for our study as we explore the boundaries of traditional asset allocation and introduce a new investable source of diversification, namely equity volatility which has the ability to provide diversification specifically when other asset class returns tend to cluster around each other. Equity volatility demonstrates singular properties in terms of risk mitigation but can also offer a diversified source of return over the long term. GRAPH 1 I CORRELATIONS VS INFLATION Dec-90 Dec-93 Dec-96 Dec-99 Dec-02 Dec-05 Dec-08 Dec-11 3 month correlation of the S&P 500 and US Treasuries (LHS) US Core Inflation % (RHS) Source: Bloomberg, between 30/09/1990 to 31/12/2013 As shown in graph 1 before 1998 correlations between stocks and bonds were positive and also demonstrated low volatility. This was strongly influenced by the relatively high level of inflation. After 1998 the Federal Reserve strived to harness inflation through applying the Taylor rule. The Taylor rule looked to set short term rates as a function of achieving the short term goal of stabilizing the economy and the long run goal for inflation. The consequence was that inflation s influence on stock and bond correlations was significantly reduced as other factors such as monetary policy, the unemployment rate and the equity risk premium began to take on greater significance. Correlation between stocks and bonds turned negative and became also more volatile in the process. It is therefore instructive to put the relationship between stocks and bonds under the microscope to identify the symptoms of changes of behavior over time. 5

6 Quantitative Research White Papers # 3 DISSECTING THE ENVIRONMENT HELPS BETTER UNDERSTAND THE LIMITS OF TRADITIONAL DIVERSIFICATION When using the same observation period (1990 to 2013) to consider the relationship between equity market and bond market returns, 4 distinct states of nature can be identified and are summarized in the chart below. GRAPH 2 I THE DIFFERENT STATES OF NATURE Stock market performance Bond market performance + Configuration 1 (stocks + and bonds -) is indicative of positive economic growth and a backdrop of increasing consumer spending. Both corporate earnings and valuations tend to be supportive and monetary policy tends to become more restrictive while aiming to control inflation and therefore having a knock on effect on rates and bond prices. There is little room for policy uncertainty and equity volatility tends to remain subdued. CONFIGURATION 1 I SUMMARY TABLE 1 MONTH AVERAGE STOCK MARKET PERFORMANCE +3.3% BOND MARKET PERFORMANCE -1.2% CORRELATION BETWEEN STOCKS AND BONDS IMPLIED EQUITY VOLATILITY (VIX INDEX) % VARIATION -7.2% INVESTIBLE IMPLIED EQUITY VOLATILITY (SPVXSP INDEX) PERFORMANCE -9.4% All data is based on daily observations between 31/12/1990 and 31/12/2013. Stock market data refers to the S&P 500 futures index. Bond market data refers to the futures 10 Year Treasury Note. The VIX index reflects a market estimate of future volatility for the S&P 500 index based on the implied volatilities for a wide range of options. The SPVXSP index measures the return from a daily rolling long position in short term VIX futures contracts traded on the CBOE. Configuration 2 (stocks + and bonds +) is indicative of a recessionary period where financing the economy has become an issue. In response monetary policy has become accommodative and interest rates begin to decrease and in turn bond prices increase. Financing tends to become cheap and risk aversion generally diminishes which in turn can lead to an increase in risky asset prices. Uncertainty will tend to remain but potentially begin to subside. 6

7 # 3 Quantitative Research White Papers CONFIGURATION 2 I SUMMARY TABLE 1 MONTH AVERAGE STOCK MARKET PERFORMANCE +3.0% BOND MARKET PERFORMANCE +1.3% CORRELATION BETWEEN STOCKS AND BONDS +0.2 IMPLIED EQUITY VOLATILITY (VIX INDEX) % VARIATION -6.0% INVESTIBLE IMPLIED EQUITY VOLATILITY (SPVXSP INDEX) PERFORMANCE -9.8% All data is based on daily observations between 31/12/1990 and 31/12/2013. Stock market data refers to the S&P 500 futures index. Bond market data refers to the futures 10 Year Treasury Note. The VIX index reflects a market estimate of future volatility for the S&P 500 index based on the implied volatilities for a wide range of options. The SPVXSP index measures the return from a daily rolling long position in short term VIX futures contracts traded on the CBOE. Configuration 3 (stocks - and bonds +) is indicative of an economic environment which is at risk of overheating. Investment growth and corporate earnings tend to decline. The level of uncertainty tends to increase along with risk aversion. Risky asset prices can decline and a flight to quality supports bond prices. The level of uncertainty generally remains high. CONFIGURATION 3 I SUMMARY TABLE 1 MONTH AVERAGE STOCK MARKET PERFORMANCE -3.7% BOND MARKET PERFORMANCE +1.7% CORRELATION BETWEEN STOCKS AND BONDS IMPLIED EQUITY VOLATILITY (VIX INDEX) % VARIATION 13.3% INVESTIBLE IMPLIED EQUITY VOLATILITY (SPVXSP INDEX) PERFORMANCE 8.4% All data is based on daily observations between 31/12/1990 and 31/12/2013. Stock market data refers to the S&P 500 futures index. Bond market data refers to the futures 10 Year Treasury Note. The VIX index reflects a market estimate of future volatility for the S&P 500 index based on the implied volatilities for a wide range of options. The SPVXSP index measures the return from a daily rolling long position in short term VIX futures contracts traded on the CBOE. Configuration 4 (stocks - and bonds -) is illustrative of an environment where the economy is slowly recovering. Anticipations around potential interest rate tightening have a negative impact on bond prices. Corporate earnings are not sufficiently resilient to absorb higher financing costs and uncertainty tends to increase and stock prices decline. Uncertainty around monetary policy remains high. CONFIGURATION 4 I SUMMARY TABLE 1 MONTH AVERAGE STOCK MARKET PERFORMANCE -3.4% BOND MARKET PERFORMANCE -1.3% CORRELATION BETWEEN STOCKS AND BONDS +0.2 IMPLIED EQUITY VOLATILITY (VIX INDEX) % VARIATION 15.1% INVESTIBLE IMPLIED EQUITY VOLATILITY (SPVXSP INDEX) PERFORMANCE 9.0% All data is based on daily observations between 31/12/1990 and 31/12/2013. Stock market data refers to the S&P 500 futures index. Bond market data refers to the futures 10 Year Treasury Note. The VIX index reflects a market estimate of future volatility for the S&P 500 index based on the implied volatilities for a wide range of options. The SPVXSP index measures the return from a daily rolling long position in short term VIX futures contracts traded on the CBOE. 7

8 Quantitative Research White Papers # 3 As shown in the tables above the relationship between equities and bonds changes over time and there are both transition periods where uncertainty remains high and the lack of visibility leads to risky assets correcting alongside bonds. Volatility in this instance provides access to a useful tool: namely a source of diversification when diversification has become a scarce resource. GRAPH 3 I FREQUENCY OF THE DIFFERENT STATES OF NATURE OVER TIME 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Stocks + / Bonds - (configuration 1) Stocks - / Bonds + (configuration 3) Stocks + / Bonds + (configuration 2) Stocks - / Bonds - (configuration 4) All data is based on daily observations between 31/12/1990 and 31/12/2013. Stock market data refers to the S&P 500 futures index. Bond market data refers to the futures 10 Year Treasury Note. The bar charts above provide greater insight around the different states of nature over time. Two configurations appear clearly on this chart since the early nineties. The lack of diversification benefits (states 2 and 4) dominated until 1999 within an inflationary context. Since then diversification opportunities have been prevalent (configurations 1 and 3) but have started to decline over the last 3 years. This pattern raises the issue of diversification among bonds and stocks during transitory periods. 8

9 # 3 Quantitative Research White Papers PUSHING THE BOUNDARIES OF TRADITIONAL PORTFOLIO DIVERSIFICATION In principle, volatility can potentially provide a source of diversification in periods of transition. It is therefore important to understand the benefits and drawbacks of investing in volatility, in addition to comparing volatility to other sources of potential risk mitigation such as cash. As shown in the chart below the integration of investable volatility (i.e. VIX futures) demonstrates that the cost of a structural exposure to short term volatility largely outweighs the benefits. The cost of carrying volatility is an expensive insurance premium which not only dampens risk within a diversified portfolio but also dampens return to a greater extent. GRAPH 4 I INTEGRATING VOLATILITY PASSIVELY WITHIN A DIVERSIFIED PORTFOLIO OF STOCKS AND BONDS 50% 40% 30% 1Y rolling performance 20% 10% 0% 0% -10% 5% 10% 15% 20% 25% 30% -20% -30% -40% 1Y rolling volatility 60 / / 32 / 20 VIX Short term Average 60 / / 32 / 20 VIX Short term futures 60/40 represents 60% equities and 40% bonds. 48/32/20 represents 48% equities, 32% bonds and 20% short term VIX futures. Analysis covering the period from end of December 1990to December 2013 is based on daily returns of the S&P 500 futures, the futures 10 Year Treasury Note and the SPVXSP Index. Integrating cash as a structural asset class within a portfolio of stocks and bonds could also provide an investor with greater diversification and more attractive risk adjusted returns. We have thus compared utilizing cash versus investing in volatility to push out the diversification frontier. The ability to buy or sell volatility provides the potential to exploit the latter as a source of risk mitigation while at other times using volatility as a diversified source of return. Considering a naive approach to volatility is therefore an interesting starting point. It consists in going long or short volatility, on a binary basis, depending on the states of nature (configurations 1, 2, 3 and 4) i.e. buying volatility in periods of uncertainty and, conversely, selling volatility in normalized conditions to harvest the premium. An advanced approach would be to consider implementing an active strategy by dialing up and down our exposure to volatility more gradually and exploit specific features of volatility, including mean reversion 1 and momentum. 1. Volatility has a tendency to revert towards its long term average 9

10 Quantitative Research White Papers # 3 Here below we show simple efficient frontiers for each of those portfolios and strategies: D represents a set of diversified portfolios of stocks and bonds. N illustrates a set of diversified portfolios of stocks and bonds with a 20% constant allocation to the naive volatility strategy relying on short term VIX futures. The flexible allocation rule consists in going short VIX futures when configurations 1 or 2 prevail while going long VIX futures in configurations 3 and 4. C consists of a set of diversified portfolios of stocks and bonds with a 20% constant investment in cash. A represents a set of diversified portfolios of stocks and bonds with a 20% constant allocation to the advanced volatility strategy with VIX futures. This strategy consists in gradually transitioning from long to neutral and neutral to a short VIX futures position depending on momentum. Short positioning strives to benefit from volatility decay (the mean reversion effect) or from the volatility premium (cost of carry). Long positions aim to exploit upward volatility movements. GRAPH 5 I EFFICIENT FRONTIER ANALYSIS OF COMPARATIVE PORTFOLIOS 19% Annualized return 15% 11% 7% 3% 3% 8% 13% 18% 23% Annualized risk D N C A All data is based on daily observations between 31/12/1990 and 31/12/2013. Stock market data refers to the S&P 500 index. Bond market data refers to the 10 Year Treasury Note. Both the Naive volatility strategy (N) and the Advanced Volatility strategy (A) integrate short term VIX futures illustrated by the SPVXSP index. The SPVXSP index measures the return from a daily rolling long position in short term VIX futures contracts traded on the CBOE. The benefits of adopting a flexible approach to volatility management become clear within the context of a diversified portfolio and pave the way to introduce equity volatility as a durable source of diversification. Another way to consider the impact of volatility investing is to apply the same analysis and observe the outcome for risk adjusted returns. 10

11 # 3 Quantitative Research White Papers GRAPH 6 I SHARPE RATIO ANALYSIS OF COMPARATIVE PORTFOLIO 1,2 1,0 Sharpe ratio 0,8 0,6 0,4 0,2 0,0 0% 20% 40% 60% 80% 100% Equity allocation D N C A All data is based on daily observations between 31/12/1990 and 31/12/2013. Stock market data refers to the S&P 500 index. Bond market data refers to the 10 Year Treasury Note. Both the Naive volatility strategy (N) and the Advanced Volatility strategy (A) integrate short term VIX futures illustrated by the SPVXSP index. The SPVXSP index measures the return from a daily rolling long position in short term VIX futures contracts traded on the CBOE. The chart above demonstrates the consistent superior risk adjusted returns derived by the integration of equity volatility as an asset class in comparison to both a diversified portfolio of stocks and bonds and also a portfolio of stocks, bonds and cash. The calendar year returns are shown here below also for illustrative purposes and highlight the limits of a naive approach to volatility (i.e and 2008 for instance). GRAPH 7 I CALENDAR YEAR RETURNS OF COMPARATIVE PORTFOLIOS 80% 60% 40% 20% 0% -20% -40% D N C A All data is based on daily observations between 31/12/1990 and 31/12/2013. Stock market data refers to the S&P 500 index. Bond market data refers to the 10 Year Treasury Note. Both the Naive volatility strategy (N) and the Advanced Volatility strategy (A) integrate short term VIX futures illustrated by the SPVXSP index. The SPVXSP index measures the return from a daily rolling long position in short term VIX futures contracts traded on the CBOE. 11

12 Quantitative Research White Papers # 3 CONCLUSION "Past performance is no guarantee of future results": this is a statement that every investor is generally familiar with. Today we could be at a crux, with historical relationships between asset classes no longer having future application. An unprecedented amount of artificial stimulus has been provided by central banks to prop up economies across different regions. This in turn has led to historically low interest rates. However a certain amount of uncertainty remains around monetary policy and future growth prospects around the globe. Financial markets are by definition uncertain however everywhere one looks that level of uncertainty seems to be increasing. Traditional asset allocation approaches have been called into question as the relationship between stocks and bonds is increasingly volatile and the negative impact of rising rates could potentially limit the diversification power of bonds within a global allocation. A first answer to overcome that hurdle would be to adopt a flexible approach to weathering short term volatility by adjusting capital allocation dynamically over time while resorting to a broad multi-asset investment universe. Heightened global market volatility over the last decade has fuelled greater interest in seeking investments that are less correlated to traditional equity markets or fixed income markets. These types of strategies are commonly referred to as global tactical asset allocation. However such approaches tend to benefit most when visibility is high and allocation decisions among asset classes can be made. Interestingly, equity volatility represents an investable asset class which is geared towards generating value in periods of transition, specifically when traditional asset classes lack visibility and are the most challenged. We therefore strongly believe that integrating actively managed equity volatility within a global portfolio provides a durable source of diversification. 12

13 # 3 Quantitative Research White Papers NOTES 13

14 Quantitative Research White Papers # 3 NOTES 14

15 # 3 Quantitative Research White Papers DISCLAIMER This document is intended for professional clients as defined by the MiFID. It may not be used for any purpose other than that for which it was conceived and may not be copied, diffused or communicated to third parties in part or in whole without the prior written authorization of Natixis Asset Management. No information contained herein shall be construed as having any contractual effect. This document is produced purely for informational purposes. It constitutes a presentation conceived and created by Natixis Asset Management from sources that it regards as reliable. Natixis Asset Management reserves the right to change the information in this document at any time and without notice. Natixis Asset Management may not be held liable for any decision taken or not taken on the basis of information contained in this document, or for any use of this document that may be made by a third party. 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16 WE FIND SOLUTIONS IN COMPLEX SITUATIONS The uncertainty of financial markets calls for new answers. To create value in such environments, Seeyond designs investment solutions that reconcile both performance and risk management. seeyond-am.com Seeyond is a brand of Natixis Asset Management. Natixis Asset Management - Limited liability company Share capital 50,434, Regulated by AMF under no. GP RCS Paris n Registered Office: 21 quai d Austerlitz, Paris Cedex 13.