Often confused with risk, volatility is the statistical measure of the dispersion (or spread) of returns for a given security or market index. It refers to the amount of uncertainty about the size of changes in a security or indices’ value.
Volatility is generally negatively correlated to other assets, particularly equities; including volatility in a portfolio potentially provides real and sustained portfolio diversification.
Why invest in volatility?
Volatility – represented by the CBOE VIX Index – is an asset class that is causally correlated to equities; it is inversely related to equity index prices, especially when there are large moves. This causal relationship, illustrated by figure one enables an investor to generate negative correlation that is persistent and reliable.
Typically, the more equities fall, the faster volatility (i.e. the VIX) rises. It has what’s called a ‘convex’ payoff profile – the more the S&P500 Index falls, the harder and faster the VIX tends to rise. In other words, when equity investors are ‘running for the door’, those investors with an exposure to volatility can reap the benefits
Australian investors have the second highest exposure to equities in the world. According to the OECD, the average superannuation portfolio has a 50 per cent allocation to equities (source: Pension Markets in Focus, OECD Report, 2014) with many having a much higher exposure.
Investors have sought to diversify their equity risk by investing in a range of so called alternative assets, including commodities and hedge funds. Post GFC, it became apparent that those asset classes were not reliably effective as diversifiers, which resulted in many ‘balanced’ portfolios experiencing prolonged negative returns.
This is illustrated by Figure two, which shows the correlation between the S&P/ASX200 Index (ASX200) and a range of other asset classes, including US equities, hedge funds and commodities. Most other asset classes are closely correlated with the ASX200, particularly in down markets.
The exception to this is the CBOE VIX Index, which exhibits strong negative correlation to the other asset classes, particularly when the ASX200 is falling.
With low correlation to other asset classes, volatility can be used to enhance returns and manage risk, potentially providing an additional source of alpha to a portfolio.
