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How can I make a profit from investing in volatility?

For the past 25 years or so the global investment backdrop has been largely focused on deflationary shocks, that is, falling demand as a consequence of competing macroeconomic forces.

In such conditions, cutting interest rates is fairly straightforward and at a time of falling inflation, bonds – especially as part of a typical multi-asset portfolio made up of 60 per cent equities and 40 per cent fixed income – might have provided enough diversification to shield against this economic environment.

Yet in today’s higher inflation world, interest rates are on the rise and bonds no longer offer the soft landing they once did to protect investment portfolios from bumpier market conditions.

Just two years into the current decade and already volatility looks to be almost as high as it has been since the 1940s. While nothing is guaranteed and the past will not necessarily dictate the future, an understanding that rising interest rates will present just as much of a risk to markets as falling rates can lead one to assume that today’s fragility may well be around for the foreseeable future.

Investment-grade corporate bonds might have once delivered twin benefits of a coupon-bearing element and duration exposure.

As a reminder, if duration indicates how a bond’s price will move in response to changes in interest rates, a bond’s convexity looks at the sensitivity of its duration in response to changes in the yield.

Positive volatility

But if bonds are not able to fulfil their previous role of downside protection against equity market falls and subsequent declining interest rates, where else might investors turn for their diversification?

If volatility is here to stay, strategies that take advantage of volatility as a positive, rather than a negative feature would be worth exploring, introducing a degree of ‘insurance’ through the explicit use of derivatives.

Looking at volatility as an asset class in its own right means that whether markets are moving up or down is irrelevant as there are opportunities to make money, or lose less money, in either scenario.

As far as volatility is concerned, the market moving up 1 per cent each day is treated the same as moving down 1 per cent each day, even if the former might be more comfortable for investors.

"Bonds no longer offer the soft landing they once did."

There are different ways to ‘buy’ volatility. One could simply buy the VIX – the Chicago Board Options Exchange's CBOE Volatility Index, a commonly used measure of the stock market's expectation of the coming month’s volatility based on S&P 500 index options.

However, its relatively high cost of ownership given that the VIX itself is not investable, and investors can only access the index via futures – typically 8 to 10 per cent a month – will eat into to any potential returns, so it is worth seeking out more cost-effective ways of investing in this asset class.

Strategies that introduce a package of options to sit as an overlay on top of their equity exposure can offer some reassurance when markets become challenging, dampening down the equity risk, should the market fall significantly.

Volatility can provide a more reliable source of negative correlation in a rising short-term rate environment, providing the offset that many clients are currently looking for, especially those who may have had their fingers burnt in March 2020.

Protection against such extreme market moves has come back up the agenda in recent years, and more innovative strategies are in greater demand.

"Whether markets are moving up or down is irrelevant as there are opportunities to make money, or lose less money, in either scenario."

Because volatility tends to mean-revert rather than plod along a trend line, markets find it difficult to realise a very high level of volatility for a long period of time and the benefit of buying near-term protection diminishes.

Selling some options today in order to buy more options further out allows the manager to adjust for the overall level of volatility. If volatility is very low, the likelihood of it going lower is minimal. If volatility is very high, the point at which you are protected moves out a little further because the uncertainty is greater.

Volatility strategies can be constructed and applied in different ways. Implied volatility is a measure of the expected movement of an asset over a set time period in the future. Implied volatility tends to rise when markets are fearful and therefore provides a consistently negative correlation to the asset itself.

This is useful when comparing volatility and bonds where the correlation profile of bonds and risk assets can vary based on other factors such as central bank movements and inflation.

Downside protection

For example, one approach – and the one we use in the Atlantic House Total Return Fund – seeks to protect the equity exposure in a fund during times of higher market stress without sacrificing performance when volatility is low.

An underlying ‘base’ multi-asset portfolio, comprised of equities, short-duration investment-grade corporate bonds, inflation-protection assets such as gold, gold proxies or inflation-linked bonds sit beneath a rules-based volatility ‘overlay’.

This component of the fund is made up of highly liquid, low-cost options on the S&P 500 index that typically sit above the equity book.

A blend of systematic protection will shield against market falls by providing a constant level of cost-efficient exposure to implied volatility, while a signals-based component will be triggered when short-term indicators suggest volatility is likely to increase, which aims to provide a layer of protection as a significant event arises, such as the invasion of Ukraine.

Deconstructing this even further, the various inputs that go into an option include interest rates, dividends, times to maturity and volatility.

"Volatility can provide a more reliable source of negative correlation in a rising short-term rate environment."

In isolating volatility as an input, expectations can be set over whether it will go up or down (implied volatility), which in turn will enable proxies to be created and allow it to be traded.

As an alternative strategy to a traditional multi-asset fund, rather than relying on the twin returns from the fixed income element, investors could seek the income or coupon-bearing element from the underlying equities and the duration element from the volatility overlay.

Such strategies are designed to protect the ‘tails’ in extreme times while offering greater downside protection in more typical conditions.

Striking that balance can be likened to an insurance policy. Paying a higher excess on your car insurance policy may feel more expensive to deal with small surface scratches but if you write the car off, those higher excess premiums will bring down the cost of replacing the car altogether.

Applying that to the options market, selling some protection that is closer to where things are today will allow the fund manager to buy multiples of that protection should the market move further out in future. The overlay will not necessarily 'kick in' unless it is really needed; taking effect at times of significant market moves rather than gentle bumps in the road.

Specialist fund managers, skilled in managing volatility and turning it into a positive part of your portfolio, will be best-placed to meet this shifting demand as they seek to deliver predictability and diversity of returns while mitigating equity risk during times of market stress.

Tom Boyle is manager of the Atlantic House Total Return Fund

This article can also be read here: FT Adviser

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