The cost of downside protection on a volatility control equity benchmark can be less than half the cost of equivalent protection on a passive equity investment, according to Redington.
The consultant said using a controlled volatility overlay strategy on portfolios allowed scheme trustees and sponsors to reduce the impact of severe market crashes by implementing more cost-effective downside protection.
Redington co-head of asset and liability management and investment strategy Dan Mikulskis (pictured) said for a fund using a volatility control benchmark the current cost of a one-year guarantee of 10% maximum loss would only be 0.9%.
By comparison, the cost of protection increased to 3.5% in a global equity index and rising to about 6.5% in stressed market conditions.
Mikulskis explained an equity volatility strategy – which Redington termed a “semi passive” product – changes exposure to equities in response to market conditions – as equity volatility rises, the exposure shifts from equity toward cash, depending on the volatility target.
Mikulskis said while traditional risk parity allocates risk to different asset classes across the whole portfolio, a volatility control strategy applies the principle of allocating risk but just to equities.
He said: “Volatility keeps trustees awake at night” and this strategy allowed them to “drive to the market conditions”.
Mikulskis said one client, who he could not name, had implemented the strategy following competitive pricing from a number of banks, with Bank of America Merrill Lynch winning the first part of the trade.
Redington also said this was attractive as an option for defined contribution (DC) default funds as it delivers better risk and return outcomes for members than a passive equity index.
Mikulskis said: “Is there a better way of creating a default with a guarantee so you cannot lose a certain amount? A volatility control benchmark provides a smoother ride and smaller falls in value.”
However, he warned the strategy was not a “free lunch” as transaction costs can still be an issue and at present there were no futures that track volatility – something Redington was currently working on.
He also cautioned the product was not a mechanism for trying to predict market crashes; nor was it a process for selecting low volatility stocks or weighting individual stocks according to their volatility. Similarly it was not designed as a guaranteed downside protection vehicle against instantaneous crashes.
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