Continuing our countdown to Christmas, Eric Hermitte puts the case for adding a long volatility exposure to a portfolio - both as a diversifier and a potential 'shock-absorber'.
Volatility is well known as a measure of an asset's variability. It describes how (un)stable an asset is. When talking about volatility, however, it is essential to differentiate between realised and implied volatility.
Realised volatility is an ex-post indicator of an asset's variability whereas implied volatility reflects the market's anticipation of an asset's future fluctuations. It is inferred from the price of options traded in the market.
While being traditionally considered as a risk indicator, volatility also combines all the characteristics of an asset class:
*Accessibility: Possibility to invest in implied volatility of equity indices via derivatives or funds.
*Diversification: Negative correlation with equity markets and un-correlation with all major asset classes and hedge fund indices.
* Performance: Volatility offers a wide range of alpha sources such as directional and arbitrage strategies.
In the current low interest rate environment, diversification benefits between traditional asset classes (equities and rates) are gone. Simultaneously, market stress and volatility have increased (for example, devaluation of the yuan in August 2015, China stress at the beginning of 2016, Brexit referendum in June).
In this context, Amundi's directional volatility strategy has been in great demand this year (with assets under management more than doubling to €4.8bn year-to-date) thanks to its diversification benefits in a portfolio construction context.
The strategy offers pure exposure to one-year implied volatility of equity markets via listed liquid options. The approach is one of active management around the mean-reverting nature of volatility.
Amundi's volatility strategy performs well either when implied volatility rises from low levels, the strategy being positioned long volatility, or when implied volatility is itself volatile and provides trading opportunities. When volatility spikes to excessive levels, the strategy can also capture a volatility normalisation by turning short volatility.
The volatility exposure is based on a simple transparent investment grid, which includes a leeway for the fund managers. This allows active management and to take into account the prevailing environment, which is key to generating performance over the long run.
While equity volatility is negatively correlated to equity markets, our directional volatility strategy, which has a long bias, offers low or negative correlation to all traditional asset classes. The strategy is thus typically used as a diversification tool in order to improve the risk/return profile of a portfolio and/or to generate absolute returns in a favourable volatile environment.
Looking forward, while uncertainties remain regarding global growth, geopolitical risks, liquidity issues and uncertainties around central banks, we do not expect volatility levels to change dramatically over the medium-term. However, in light of the various risks, we expect increased fluctuations of volatility.
In this environment, adding a long volatility exposure to a portfolio as a diversifier and possibly a shock-absorber is a prudent course of action.
Eric Hermitte, Co-Head of Volatility and Convertible Bonds, Amundi
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The views and opinions contained herein does not constitute advice. This has been created for financial adviser use only, and is not intended for use by individual investors. Past performance is not a guide to future performance. The value of an investment can fall as well as rise and is not guaranteed which means your clients could get back less than they invest.
