- The result of regulatory requirements such as Solvency II and Basel III means that increasingly, more market participants are required to buy protection against large market drawdowns than there are those prepared to sell.
- Having just traversed a large market and volatility shock brought about by the Coronavirus pandemic, the acute risk of a market downturn, especially one resulting from an exogenous shock, is fresh in the minds of many investors. The opportunities are now very much skewed in volatility sellers’ favour.
- Seeyond developed and launched a Volatility Risk Premium strategy in 2017 with a performance potential and risk profile that straddles both equities and high yield credit, providing investors a robust and valuable asset allocation brick to diversify their portfolios.
Loss Aversion, It's in Our Nature
The volatility risk premium exists largely thanks to human nature and represents the premium that investors are willing to pay in order to protect themselves against large market movements. It is a consequence of a famous behavioral bias called the loss aversion. The term ‘loss aversion’ was originally coined by behavioral economists Amos Tversky and Daniel Kahneman in a 1979 paper on subjective probability.
Loss aversion implies that one who loses 100 Euros will lose more satisfaction than another person will gain satisfaction from a 100 Euros windfall.
Loss aversion is something that is deeply encoded in human nature, so much so that sometimes it ends up becoming a regulatory constraint. Take bank stress tests that have become an increasingly popular regulatory instrument since their introduction in the early 90s, albeit originally conducted as an internal self-assessment.
Stress tests require banks to simulate that in the event of an extreme market shock, they will not lose too much money. They must pass or face regulatory intervention. In the insurance industry, the Solvency II framework follows a similar principle. Insurance companies are required to set aside a solvency capital ratio in accordance with the loss they would suffer in case of a sudden market shock.
The result of these regulatory requirements means that, increasingly, more market participants are required to buy protection against large market drawdowns than there are those prepared to sell. As a consequence, sellers have the upper hand in the negotiation and therefore generally ask for a premium to take on the risk. This premium is called the volatility premium. During long periods where volatility is low, sellers of volatility will be able to cash in on this premium. But of course, they will also inevitably suffer some losses from time to times when volatility spikes, like every other risk premium.
The concept of the volatility premium can be likened to the business model of an insurance company. Insurance companies collect ongoing insurance premiums form their customers, but only have to cover customers’ claims in the event of an accident or disaster. Of course, if there are many accidents or disasters the insurance company will face a large loss, but will then inevitably increase customers’ insurance premiums as a result, paving the way for future returns.
Having just traversed a large market and volatility shock brought about by the Coronavirus pandemic, the acute risk of a market downturn, especially one resulting from an exogenous shock, is fresh in the minds of market participants. In spite of the fact that many market indices have rebounded strongly, volatility remains very high and therefore the volatility risk premium is very large.
In a similar way that sales of insurance policies against an event or disaster tend to increase after the event has occurred – pandemic insurance being a particularly poignant example – so too has the interest in protection against the next downturn. Couple this with the fact that the volatility risk premium exists thanks to human psychology and is now, to a certain extent, underwritten by the regulatory landscape, it is a particularly opportune moment for investors to capture this return stream in their portfolios.
Beware the Hidden Risk
When it comes to volatility strategies, Seeyond stresses the need for investors to beware hidden risks. To a certain extent, for any strategy that makes use of derivative products, the devil is in the detail. As for any risk premium strategy, the volatility risk premium can suffer losses in adverse conditions. In a bid to mitigate these losses as best as possible there are two key levers to building a robust and sustainable short volatility strategy; risk selection and risk calibration.
Risk selection is very important, because there are some risks that are worth taking and others that you want to avoid. Aninat describes, “The most vicious risks are those that we term hidden risks. Hidden risks are those that can stay silent for years but could blow-up completely in the event of severe crisis like the Great Financial Crisis or the Covid-19 crisis.”
“Obviously, hidden risk products can take many forms, but typically what they have in common is that they tend to function very well as long as the underlying instrument stays above a certain level, during the life of the product. In this event, the product will generate an attractive and regular coupon or capital gain. However, in the event of a severe crisis, when the market or instrument falls below the threshold, the result is a very significant loss.” adds Aninat. It is important to be aware of these inflection points, even if they may seem to have little proximity to current levels, as this is the perfect example of a hidden risk.
Another type of hidden risk lies in correlation. For example, during periods of market calm, investors may believe themselves to be properly diversified because short drawdowns in equities may be offset by gains in bonds. However, as has become evident with increasing frequency over the last decade, in the event of severe drawdowns, correlations between asset classes can quickly approach one. Equities, Govies and Credit all go down together in lockstep. This occurred as recently as March 2020, when government bonds and equities were selling off at the same time for a number of days. Just like the instrument that can be profitable for long periods until its inflection point is breached, a portfolio can appear diversified until, well, it isn’t.
When managing its short volatility strategy, Seeyond identifies and selects risks carefully with the objective to avoid hidden risks as much as possible, meaning that they prefer to invest in products that will not become more risky when the markets are in stress. They also avoid the temptation to pile up on leverage and risk during quiet periods.
“It can be very tempting to add more risk and increase positions when markets are calm in a bid to generate larger returns.” Aninat Says. “If you do so, as soon as the market does become more volatile, you are forced to reduce your positions in order to respect your risk budget, and end up reducing risk at exactly the wrong time.”
“Instead, we have a contrarian approach. We want to reduce risk when volatility is low and markets are quiet to give us room to increase our positions when volatility starts to return. To paraphrase Warren Buffett, when volatility is low and investors are greedy we want to reduce our risk, but when volatility spikes and investors are panicked, we want to be adding risk. This contrarian philosophy is very important to us and is an approach that is common to all of our volatility strategies.”
A Litmus Test for Volatility Sellers
Of equal importance to the avoidance of hidden risks, strategy design and structure is another key consideration in capturing the volatility risk premium.
Volatility strategies can be complex and difficult to fully grasp, even the most advanced investors. As a portfolio manager of such a strategy there are two very different ways to address this.
The first, which is a popular method among some hedge funds, consists of explaining to investors that the strategies and products are so complicated and technical that is better for them to simply judge the strategy based on its overall performance and risk profile and not seek to try to understand all of the underlying components. If the manager builds a track record with a good risk return profile over time, investors are ultimately convinced to invest with confidence in the strategy.
The second approach is to structure and build a transparent and liquid volatility strategy using plain vanilla options and index futures that behaves in a comparable way to strategies with which investors are already familiar. Seeyond have chosen the latter. Aninat explains, “We believed that by anchoring our strategy with a performance potential and drawdown risk profile straddling equities and high yield credit, it would give investors a better understanding of what to expect and the role the strategy could play in a portfolio. This means that investors can diversify either their equity or high yield credit allocations with a new asset allocation brick that will help build a more diversified portfolio profile over the long term.”
“Our volatility risk premium strategy has been live since 2017, but 2020 has proved to be somewhat of a litmus test. It was a significant year given the significant moves in volatility, which spiked to its highest level since the Global Financial Crisis. While, of course, we did not avoid every risk in 2020, we succeed in avoiding the most hidden and toxic risks witnessed in the market.”
Thanks to Seeyond’s contrarian philosophy, they were able to capitalize on opportunities that the market dislocation that emerged in March 2020, always careful to add risk only when volatility was very high and the market was oversold. In spite of being short volatility throughout the year, Seeyond’s Volatility Risk Premium strategy delivered a net return in excess of 8% (c.13% since inception on 29/12/2017) with a maximum drawdown of 13% in March that was recovered in just 89 trading days¹. Having successfully traversed a year like 2020 and with volatility remaining elevated in spite of many market indices once again posting record highs the opportunities are very much skewed in investors favour and such a strategy has the potential to provide a robust and attractive new asset allocation brick for institutional investors’ portfolios.
Published in February 2021.
Past performance does not guarantee future results. Main risks of the strategy: capital loss risk, volatility-linked risk, risk related to the underlying asset, model-based risk.
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