Institutions move to add volatility strategies
Separate allocations gaining momentum; classification queried
By Christine Williamson | March 4, 2013
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. n
This article originally appeared in the March 4, 2013 print issue as, "Institutions move to add volatility strategies".