Thursday, March 7, 2013

Confusion Over Volatility Strategies?

Christine Williamson of Pensions & Investments reports, Institutions move to add volatility strategies (h/t: Bryan Wisk):
A number of institutional investors intend to carve out an allocation in their asset mix for volatility strategies, despite consultants' views that volatility is not yet a formal asset class.

Stanford Management Co., Palo Alto, Calif., which runs Stanford University's $20 billion endowment, for example, is “trying to fine-tune our asset allocation,” said Vera Kotlik, director, absolute return and fixed income, during a panel discussion of large institutional investors at the Global Volatility Summit held in New York on Feb. 25.

SMC's investment staff is in “the nascent stage” of research with respect to how long volatility strategies may fit in, Ms. Kotlik said, noting “it's clear that there's real value in volatility strategies.” She said the staff is looking at both relative value hedge funds and long volatility strategies and is researching whether there is a place for a separate allocation to volatility managers.

“We're looking for key relationships,” Ms. Kotlik said.

China Investment Corp., Beijing, on the other hand, is more likely to work with one of the existing relative value managers within the sovereign wealth fund's $15 billion hedge fund portfolio to add tail-risk hedging, said Roslyn Zhang, managing director, fixed income and absolute return.

CIC, which has $200 billion invested outside of China, conducted “extensive research” on dedicated tail-risk hedging strategies after the 2008-2009 financial crisis but found the approaches costly and difficult to size appropriately, as well as hard to execute with regard to timing, Ms. Zhang said.

The sovereign fund also would consider treating volatility management investments as an asset class allocation and prefer using separate accounts to permit flexible customization, Ms. Zhang said. Other speakers on the panel have been managing pension portfolio volatility internally using derivatives for some years, including Marc-Andre Soubliere, vice president fixed income and derivatives for Montreal-based Air Canada's C$10.9 billion (U.S.$10.6 billion) pension fund.

Sanjay Chawla, senior director, global asset allocation and absolute return for The Dow Chemical Co., described how he and his team are tactically trading volatility in the company's U.S. defined benefit pension plans, which total more than $12 billion.

The strong institutional investor interest notwithstanding, “volatility is not an asset class — yet,” said Samuel E. “Q.” Belk IV, director of diversifying assets at Cambridge Associates LLC, during a lively panel of investment consultants.

While controlling the volatility of institutional portfolios is an “enormously important area” for clients of the Boston-based institutional investment consulting firm, Mr. Belk added that volatility management strategies today are like “venture capital companies in the '70s.”

“Volatility is a statistical measure of dispersal of returns,” stressed Claire Smith, partner and research analyst based in the Geneva office of alternative investment consultant Albourne Partners Ltd., London.
'Isn't an asset class'

“Volatility isn't an asset class. It's a derivative of other asset classes,” said Ms. Smith, a specialist in quantitative and volatility hedge fund strategies.

The widely varying experiences and approaches described by institutional investors at the volatility conference demonstrated that “there is something for everyone in volatility management” when it comes to portfolio construction and management issues, said Paul Britton, whose idea it was to bring investors and managers together to focus just on volatility issues.

Mr. Britton is founder and CEO of Capstone Investment Advisors LLC, London, which manages $2 billion in a relative value volatility hedge fund and $200 million in a tail-risk fund.

Mr. Britton acknowledged that tail-risk approaches to managing volatility were down on average between 12% and 20% in 2012 and investors are finding it “very hard to put money into anything producing negative returns.”

However, he is bullish that volatility will rise as financial institutions continue to reduce leverage in their balance sheets ahead of next year's regulatory milestones such as the Volcker Rule, which is due to be implemented by July 2014. He sees this period as a pivotal transition that could bring very interesting opportunities for hedge funds to enhance their balance sheets to replace the capital that the banks were once able to provide to the capital markets.

Mr. Britton said he expects that the Chicago Board Options Exchange Market Volatility index, the most widely used measure of the implied volatility of the S&P 500, will experience extremes both on the downside and the upside as the buffers that the bank balance sheet once provided continue to shrink.

Those extremes are exactly what Mr. Britton and his cohorts in volatility management are waiting for.

“It's a moral dilemma for volatility managers. We're happiest when things blow up,” he quipped.
There is so much confusion about these so-called volatility strategies. I agree with Claire Smith, volatility isn't an asset class, it's a derivative of other asset classes.

As far as "tail-risk hedging strategies," the China Investment Corporation (CIC) is absolutely right, the approaches are costly and difficult to size appropriately, as well as hard to execute. And they have been bleeding money ever since 2009 as the bull market that gets no respect keeps climbing to record highs.

The article also mentions Marc-André Soublière, VP Fixed Income and Derivatives at Air Canada Pension Fund. I worked with Marc-André at PSP Investments and can tell you you he's an excellent TAA manager who knows how to structure volatility trades using derivatives to take intelligent risk.

Air Canada's pension woes aside, can also tell you that the people now managing their pension assets are doing a stellar job. They're outperforming their peers by basically following closely what the Healthcare of Ontario Pension Plan (HOOPP) and Ontario Teachers' Pension Plan (OTPP) are doing in their approach to managing assets and liabilities using derivatives and repos.

But getting back to these tail-risk hedging strategies, I've covered this topic last year in a comment on hedging against disaster, noting the following:
The market hasn't "priced in" a eurozone break-up for the simple reason that it won't happen. All these hedgies waiting for a "Lehman-style event" so they can score big are collecting 2 & 20, selling fear to their institutional clients.

The biggest and most powerful hedge funds in the world stand ready to pump up the jam. The black swan of 2012 remains a mild eurozone recession. When fears of a eurozone break-up dissipate, greed and massive liquidity will drive all risk assets much, much higher. That remains my prediction, and if I am wrong, God help us all!!
Well, it turns out I was right, all the managers that took a risk-off approach fearing the end of the world are the ones that underperformed most in 2012. Meanwhile, a few brave investors and a small Greek pension fund that nobody has ever heard of made a killing looking well beyond Grexit.

There is something else that Neil Petroff, CIO of Ontario Teachers' once told me: "Tail-risk hedging strategies for a pension plan with long-term liabilities going out 75+ years just don't make sense." Instead, Neil and his team focus on active management, taking intelligent and opportunistic risks, and he changed the incentives for senior pension officers at Teachers' to curb excessive risk-taking behavior.

What else are pension funds doing to deal with volatile stock markets? As I mentioned in a recent comment, they're moving into private markets, investing in real estate, private equity and infrastructure, taking on illiquidity risk.

But as Jim Keohane, President and CEO of the Healthcare of Ontario Pension Plan (HOOPP) mentioned in that comment, this just masks volatility and you still need to make sure you receive a high enough risk premium to compensate you for taking on risks peculiar to private market assets.

What else are institutional investors doing to curb volatility in their portfolio? Some investors are taking a smart beta approach while others like Batterymarch are focusing on low-volatility strategies in their equity portfolio:
In our view, one of the keys to a successful low-volatility strategy is the decision to invest only in dividend-paying companies. The regular payment of dividends is often an indicator of disciplined corporate decision-making and sound financial health, and research suggests that dividend-paying companies have better-quality earnings.

Dividend-paying funds have been gaining interest among risk-weary investors. However, unlike low-volatility products, these vehicles are designed primarily to produce yield and are not structured to reduce absolute volatility. From a volatility-management perspective, the fact that a company pays dividends—or that its dividend yields are high—is not enough to accurately assess the expected stability of its stock performance. For example, the highest-yielding stocks tend to be distressed companies with artificially high yields and greater volatility. Therefore, we believe that a meaningful analysis must combine dividend yield with both dividend growth potential and dividend sustainability measures, including cash flow indicators.

An investment manager’s methodology for assessing risk is another critical element in constructing lower-volatility portfolios. The danger for many managers is an over-reliance on historical correlations and other backward-looking measures to predict volatility, essentially assuming that history will repeat itself. A more effective approach, based on our research, is to take a diverse outlook that includes both statistical and fundamental insights—in other words, pairing quantitative measures of risk with a fundamental view toward companies that are likely to deliver more stable returns over time.
You have to be extremely careful when investing in companies paying out high dividends. Just look at the 3-month chart of Cliffs Natural Resources (CLF) to understand how you can lose big once they slice that big fat juicy dividend in half or more (click on chart):


OUCH! That type of move to the downside from a high dividend stock will kill you but smart money shorted this company waiting for the cut in its sky-high dividend (some dividends are more vulnerable than others).

Then there are banks like Bank of America (BAC) which was the top performing stocks in the Dow last year. It has yet to announce a hike in its dividend but when it does, the stock will surge higher.

Back to the topic on volatility strategies for institutions, spoke to a buddy of mine who is one of the smartest quants I know. Unlike others, he has years of experiencing managing money and knows all hedge fund strategies inside out. Would love to see him start his own fund here in Montreal.

My buddy thinks that volatility strategies are not an asset class and the China Investment Corporation is taking the right approach shunning tail-risk hedging strategies. But he doesn't agree with Neil Petroff either because he feels that taking a long-term view on tail-risks is just a "convenient response."

What does my buddy believe? Simple. He thinks the best way to curb volatilty is to 1) find negative beta managers that consistently make money; 2) Buy long-vol managers that consistently make money and 3) keep your mouth shut and don't share any information on them.

He also shared the following: 
If you can raise the portfolio Sharpe ratio to 4 (good luck), who cares if it's defined as an asset class or just  a low beta strategy? It does not matter how it is defined, what matters is how it helps the portfolio. This is a silly argument. The real question is does tail hedging work and is it worth the cost? Sure it is hard to time, but if you can buy a long vol strategy or a short stock strategy that makes money with a good Sharpe ratio then it would it should be included in the portfolio....Look at Goldman, they take intelligent risks which is why they rarely have a losing day trading.
I agree, investors are getting tied up in semantics and missing the larger point of how to properly improve their overall portfolio to reduce risk and increase diversification while keeping costs down. No easy feat in a historic low bond yield environment where central banks are engaging in massive quantitative easing.

Below, MKM Partners Options Strategist discusses his plays in a low implied volatility market. He speaks on Bloomberg Television's "Lunch Money."