The Long and Short of Volatility Investing

The Long and Short of
Volatility Investing
Alternatives
Greg Meier
Vice President
Investment Strategist
US Capital Markets
Research & Strategy
Duration measures the
change in a bond’s price
resulting from a 1 %
change in interest rates.
Convexity measures
the rate of change in
duration. All else equal,
when interest rates are
low, convexity is high,
meaning that even
small shifts in interest
rates can create outsize
adjustments in bond
prices.
1
2
Data source: FactSet.
In an environment of stretched valuations, tight liquidity in some
markets, high government debt levels and divergent central bank
policies, many investors are wondering what to do. For some,
alternatives may be the answer. Within the “alts” universe, option
strategies seek to produce a steady income stream – not unlike bonds.
However, unlike bonds (and equities), option strategies can be market
agnostic, meaning returns can be designed to be uncorrelated with
the ups and downs of traditional markets. In the post-crisis era –
where uncertainties abound – this may make it easier for investors to
get a good night’s rest.
Understand: One of the conclusions from our
recent Investment Forum in New York is that
alternative asset classes are becoming ever
more relevant.
Act: As our clients search for new, durable
sources of alpha, we think that liquid and
illiquid alternatives strategies should offer
positive return opportunities.
A challenge to conventional thinking
Today’s market landscape presents some challenges
for conventional asset classes. Core fixed income,
for instance, smells like misnomer: The “income”
provided by developed market sovereign bonds
has become so meager that it is hardly sufficient to
meet the needs of a retiree, much less the goals of
someone trying to cobble together a nest egg. And
while investors largely understand the detrimental
impact from low yields and the inverse relationship
between bond yields and prices, some may not
realize that when yields rise from extreme lows,
the price impact is magnified via the mechanics of
duration and convexity.1
From an equity standpoint, there are plenty of
pockets of opportunity in the market, particularly
for active managers. But for passive investors, the
“easy money” has probably been made. The MSCI
All Country World Index (MSCI ACWI) – a global
benchmark of 2,478 stocks from 46 developed and
emerging countries – has more than tripled from its
trough in March 2009.2 Shares have rallied so hard
and so fast that gains have outpaced the recovery in
company earnings. As a result, valuations for some
regions and market sectors may no longer appear
Focus: The Long and Short of Volatility Investing
super-attractive. All else equal, this means future
returns could be lower than the outsize 15 % average
annual gain in the MSCI ACWI since 2008.
Expanding the investment universe
Reflections of these challenges were evident in the
2015 edition of Risk Monitor3. When asked about
their portfolios:
• 76 % of large investors identified interest rate
risk as the greatest threat over the next twelve
months
• 25 % said equities pose a considerable threat
• Slightly more than 40 % of investors predicted
a “black swan” event in the coming year, with
potential culprits ranging from an oil price shock
to sovereign default and asset bubbles
After the trauma of the Great Financial Crisis, and
given the fact that investing naturally involves risk,
these results are not unexpected. Also perhaps
unsurprising: Nearly 75 % of large investors said
they were investing in alts, with the primary
benefits identified as portfolio diversification (41 %),
higher returns than conventional debt or equity
investments (26 %), risk management (15 %) and
management of liabilities and longevity risk (11 %).
Options as an asset class
For investors looking for opportunities in the alts
space, volatility strategies can add an uncorrelated
source of alpha to a portfolio by capitalizing
on structural inefficiencies that exist in options
markets.4 The inclusion of low-correlation assets
can move a portfolio out on the efficient frontier,
improving its risk / return profile.
See Allianz Global
Investors RiskMonitor
2015 – Global Edition.
Risk Monitor is a
yearly survey of 735
institutional investors
from North America,
Europe and Asia-Pacific
administered by Allianz
Global Investors in
collaboration with
CoreData Research.
3
Volatility of a portfolio =
its standard deviation
Volatility as an asset class =
options and other related instruments
Option-based strategies can be compelling because
of their ability to be non-directional. By focusing
on magnitude rather than direction, options- and
volatility-based strategies can pursue returns
whether markets are up, down or flat. This type
of approach can be a powerful diversifier to an
investment portfolio – and even to the alternatives
allocation within a portfolio – because so many types
of strategies are predicated on correctly forecasting
the direction of an asset or economic variable.
See Figures 1 and 2
for a comparison of
insurance policies with
options.
4
Because of their versatility, options can be used in
pursuit of return generation, risk reduction, or a
combination of both. While it is difficult to forecast
the future market environment, options provide
the ability to construct portfolios for conditional
outcomes (i. e. if this happens, our return and risk
would behave like this, and so on). As a result,
options can be used to pursue all-weather return
potential, with an ability to navigate a very wide
range of market scenarios.
Options can be combined in so many different
configurations that the potential for mathematical
innovation is high. And yet the instruments
themselves are daily priced, liquid, exchange-traded
contracts. As a result, options can be used to create
a portfolio that is sophisticated in its construction yet
still quite client-friendly.
Figure 1: Options Analogy: Insurance
Cost of Contract
Payout Threshold
Insurance Policy
Option
Premium
Premium
Deductible
Strike Distance
Property etc.
Equity Exposure
How Long Contract Lasts
Term
Time to Expiration
Subjective Pricing Factor
Underwriting Risk
Implied Volatility
Underlying
Figure 2: Insurance Analogy Revisited
Insurance Policy
• Buyer
• Protection against a loss for a
premium (Home, car, etc.)
• Insured
• Seller
• Premium collection in
exchange for risk
• Insurance company
Option
• Buyer
• Protection against a loss for a
premium (Equity portfolio)
• “Long Volatility” investor
• Seller
• Premium collection in
exchange for risk
• “Short Volatility” investor
Source: Allianz Global Investors
2
Focus: The Long and Short of Volatility Investing
The long and short of it
While volatility – in this case defined as the Chicago
Board Options Exchange Volatility Index (i. e. the
“VIX”) – is an efficient and arbitrage-free asset
class, there are still opportunities for investors to
take advantage of serial mispricing of VIX options
contracts.4
The VIX Index measures the implied volatility
of at-the-money, 30-day puts and calls on the
S&P 500. It is driven by supply and demand.
For example:
• Investors’ worrying about a prospective
decline in equities pushes up demand for
VIX puts (the option to sell the VIX at a
price that is higher than today’s price).
• The increase in demand drives options
prices higher, which equates to a higher
level on the VIX and higher levels of implied
volatility.
This is why the VIX is sometimes called Wall
Street’s “Fear Gauge”: The higher the VIX, the
greater the implicit expectation of a decline in
the S&P 500.
One area where this is evident is implied versus
realized volatility. Implied volatility is the degree
of volatility investors believe might occur in the
future – it is derived from the price investors pay
for VIX call options. Realized volatility – the actual
observed volatility of the S&P 500 Index – tends to
be lower than implied volatility because investors
usually buy more insurance against the likelihood of
a market crash than they actually need (see Figure
5). As a result, as long as sellers of VIX options have
the wherewithal to survive the inevitable market
downturn, they may profit by capturing volatility risk
premia.
There are two types of volatility in the
world of options:
• Implied volatility – expected
• Realized volatility – observed
Figure 3: “Long Volatility” Strategies
This is for guidance only.
PROS
• Designed to generate profits in highly volatile
markets
• Provides tail-risk protection against market shocks
The CBOE Volatility
Index measures the
cost of S&P 500 Index
options. A high VIX
suggests that investors
are willing to pay more
than usual for insurance
against prospective
swings in the S&P 500.
The VIX is the most
widely used measure
of market volatility, and
exchange-traded VIX
options are the most
liquid and transparent
contracts in the options
market.
4
CONS
• Very costly due to time-premium erosion and
implied-realized spread
• Often relies on an uncommonly large market
move for strategy to pay off
Figure 4: “Short Volatility” Strategies
This is for guidance only.
PROS
• Designed for consistent profits in normal markets
• Time is on your side, as is implied- realized spread
CONS
• Tail risk exposure: Can the strategy survive a
market shock?
• Relies on history repeating itself
Buyers of VIX options are on the opposite side of
the trade: They want insurance in case of a market
sell-off. But the price of protection can get expensive
quick, typically costing a portfolio 5 – 7 % per year.
Given that volatility isn’t necessarily mean-reverting,
and assuming that severe crashes might only occur
every three or four years, the compound cost of
insurance can easily top 30 % of assets by the time it
is needed.
What this means is there can be opportunites
to profit and protect in a portfolio that carefully
structures both short and long volatility positions.
Strategies that do so need to find a delicate
equilibrium between these two conflicting exposures,
or else the portfolio might wind up just being a
complicated means of earning the risk-free rate.
3
Focus: The Long and Short of Volatility Investing
A well constructed long-short volatility strategy has
the ability to consistently benefit from the fear- and
greed-driven behavior of option-market participants.
The goal is to capitalize on the return-generating
features of selling options (short volatility) while
simultaneously benefiting from the risk-control
attributes associated with buying options (long
volatility), and to continually optimize the balance
between these two types of exposures (see also
Figures 3 and 4).
Forecasting the direction of volatility is just as
hard as predicting the future of equities and fixed
income markets. Being long and short volatility
simultaneously can help reduce the risk of being
caught wrong-footed in the options market,
while generating a resilient return stream that
is uncorrelated with the challenges that affect
conventional asset classes. A long-short volatility
strategy can add value – not only when traditional
bond and equity markets seem off-kilter – but in
any environment. Think of a long-short volatility
investment as a stand-alone strategic portfolio return
enhancer, rather than a tactical asset allocation bet.
Figure 5: Typically, Implied > Realized Volatility
• Option prices usually overestimate the likelihood of an equity-market move –
This naturally favors option sellers at the expense of option buyers
• But not always …
90%
80%
70%
60%
50%
40%
30%
20%
10%
VIX Index
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
0%
Realized Volatility
Sources: Chicago Board Options Exchange, Allianz Global Investors. Implied volatility data reflect daily closing prices, over rolling 22 trading
day periods from January 1990 to September 2010, of the CBOE Market Volatility Index (VIX), a measure of market expectations of near-term
volatility conveyed by S&P 500 index option prices. Realized volatility is calculated based on the daily change in closing prices of the S&P 500
Index over rolling 22 trading day periods from January 1990 to September 2010. Past performance is not a reliable indicator of future results.
Imprint
Allianz Global Investors GmbH
Bockenheimer Landstr. 42 – 44
60323 Frankfurt am Main
Global Capital Markets & Thematic Research
Hans-Jörg Naumer (hjn), Ann-Katrin Petersen (akp),
Stefan Scheurer (st)
Allianz Global Investors
www.twitter.com/AllianzGI_VIEW
Data origin – if not otherwise noted:
Thomson Financial Datastream.
Calendar date of data – if not otherwise noted:
October 2015
4
Further Publications of Global Capital Markets & Thematic Research
Active Management
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and the Need for More Active Management
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→→ Volatility as an Asset Class
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of Financial Repression
Behavioral Finance
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→→ Behavioral Finance – Two Minds at work
→→ Behavioral Finance and the Post-Retirement Crisis
→→ Between a flood of liquidity and a drought
on the government bond markets
→→ Liquidity – The Underestimated Risk
→→ Macroprudential policy – necessary, but not a panacea
Strategy and Investment
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