Virtually all financial markets have suffered turmoil, and volatility has soared as a consequence. Declining stock prices have created a surge of volatility that implies a pronounced market slump, but that could also create opportunities for portfolio managers. In this situation, they can take advantage of volatility by systematically incorporating it into their portfolios.

“IN THE INSTITUTIONAL SPACE there is growing investor demand for volatility to be used not only as a risk measure or for hedging purposes, but also as a new asset class,” says Dr. Reinhold Hafner, a managing director at risklab. There are two reasons for this. First when volatility is used as an asset class, it has historically provided an attractive return opportunity to investors, even though the performance of the volatility asset class is suffering in the current environment. Second, it helps diversify existing asset classes.

How can one implement this approach? The standard methods are based on option strategies, such as long positions in straddles or strangles. However, to establish and maintain a lasting volatility position, it is necessary to make frequent, cost-intensive adjustments to the portfolio weights. “A more effective instrument to trade volatility from an investor’s perspective is variance swaps,” says Hafner.

Variance swaps represent a special type of forward contract. Closing a variance swap for an exchange of payment refers to the difference between the variance that is realized during the swap’s lifetime and the swap rate of the underlying determined at the outset of the deal. The swap rate corresponds to the expected realized variance. The latter, in turn, is calculated based on the average of all actively traded option prices of a given maturity and is closely linked to the implied volatility. The difference between the variance to be realized and the swap rate of the variance is generally referred to as the risk premium of variance or volatility (variance risk premium).

TO ACHIEVE MAXIMUM DIVERSIFICATION in an equity portfolio, (implied) volatility has to be purchased, since implied volatility movements and stock price movements are highly negatively correlated. Such a strategy provides “protection” and may be advantageous in environments with extreme volatility spikes and equities plunges. However, in the long run, such a “protection strategy” is costly. Historically, the negative variance risk premium has overcompensated for the diversification effect and the provision of tail risk insurance. “So, from a long-term investment rather than protection perspective, it is more advisable to systematically sell volatility,” says Hafner. Relying on this philosophy and encouraged by significant research, risklab has developed a strategy that provides efficient access to the variance risk premium and volatility as an asset class (VPT strategy). “The objective of this strategy is to earn the variance risk premium (beta), which on average is markedly negative by systematically short-selling variance swaps, in a fully rules-based way,” explains Dr. Bernhard Brunner, co-responsible for designing and implementing the VPT strategy.

“The preferred financial instruments for VPT are variance swaps on stock indices with maturities of less than three months, as the variance risk premium tends to be more negative for shorter maturities than for longer maturities,” adds Brunner. Even though volatility is an attractive asset class in the long run, it has risks. This is obvious in the current market where short-term realized volatility has reached unprecedented levels causing substantial losses in these type of short variance strategies. In that sense, the volatility asset class shows a highly skewed risk/return profile. This raises the question of whether the negative risk premium will exist in the future. “We think so,” answers Brunner, “as the main driver for the negative risk premium is the structural excess demand for out-of-the-money put options. And anticipated changes in regulations as a result of the financial crisis may mean many institutional investors are forced to buy even more protection than in the past, which in turn makes the risk premium even more attractive.”

“As the strategy is purely derivatives based, it can be customized to the individual risk/return preferences,” explains Hafner. When calibrated to achieve an equity-like return in the long run, the downside risk of the volatility asset class is significantly lower than that of equities in “normal times” and similar in magnitude in situations of extreme crisis, like now. “Considering average correlations ranging from 0.5 with stocks to -0.2 with bonds, we are talking about an interesting investment opportunity for long-term investors.”