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Asset owners, fearful of volatility, flock to risk mitigation strategies

Paul A. Britton believes institutions are becoming more comfortable with using volatility strategies.

Updated with correction

Rising volatility is motivating asset owners to take a close look at investment strategies that mitigate risk or seek to find alpha from the choppy, unsettled markets many see on the horizon.

Volatility managers running long- and short-volatility strategies and tail-risk specialists report a sharp rise in inquiries and investment, particularly from institutions.

Sources said this year's modest increase in volatility — the average value of the Cboe Volatility index year-to-date through June 30 was 16.322 compared to 11.090 in 2017 — and ongoing concern about the impending end of the equity bull market has swelled the pipeline of potential new business for institutionally oriented volatility managers.

The consensus among volatility specialist managers interviewed forecasts a return of the VIX to its normal range — mid teens to low 20s — going into 2019.

"Institutional investors increasingly are understanding how volatility strategies fit into their portfolios," said Paul A. Britton, founder and chief executive officer of global volatility specialist manager Capstone Investment Advisors LLC, New York, during an interview at the firm's annual global volatility conference in New York in March.

"Seven or eight years ago, institutions didn't know what to do about volatility, but now they're in the third or fourth inning when it comes to increasing their understanding of and investment in volatility strategies," said Mr. Britton, who is based in New York.

In an interview this month, Mr. Britton attributed a surge of interest and investment in Capstone's volatility and tail-risk protection strategies from U.S. corporate and public pension plans to anticipation of lower annual equity returns (5% to 7%) over the next five years and a higher level of volatility.

"That's a nasty mix," he said, noting that investors are considering tactical ways to bank recent equity gains by lowering their equity exposure and replacing some of that allocation with volatility strategies.

In fact, about $2.5 billion of Capstone's $5.8 billion of assets under management are in the firm's S&P 500 derivatives strategy.

Spike in interest

The combination of higher volatility and lower expected equity returns has led to a spike of interest in substituting volatility approaches for equity strategies from clients of hedge fund consultant Aksia LLC, New York, said Ken Chen, senior analyst, macro and quantitative strategies.

"The conversations I have with clients about volatility strategies are very different than those about long/short equity or market-neutral hedge funds" because volatility strategies are usually expected to have a more defined impact on the risk profile of institutional portfolios, Mr. Chen said.

Recent institutional investors that have invested in or are searching for volatility strategies include:

  • the $19.2 billion Illinois State Universities Retirement System, Champaign, hired three options-writing volatility strategies to run a total of $380 million — Neuberger Berman ($190 million), AQR Capital Management LLC ($95 million) and Gladius Capital Management LP ($95 million) in February.
  • Merced County (Calif.) Employees' Retirement System invested $5 million from the $825 million plan in a market-neutral volatility-arbitrage hedge fund managed by Laurion Capital Management LP in March.
  • Brunel Pension Partnership, Bristol, England, began a search in April for two managers to run about 600 million ($794 million) in global low-volatility strategies.

Brunel, one of eight national Local Government Pensions Scheme pools, has about 28 billion in assets from 10 U.K. local government pension funds. It's turning to low-volatility strategies to reduce risk as one of its first two equity strategies, said Mark Mansley, chief investment officer at Brunel, in an April 23 announcement from the partnership.

"Low volatility is one of the most intriguing areas of the smart beta revolution and a good fit for investors seeking to reduce equity risk. We are particularly interested in hearing from managers able to address risk of valuation bubbles in low-volatility strategies, and able to use ESG considerations to help further reduce risk," he said in the release.

Finding ways

Merced County in California's Central Valley has been working with new general investment consultant Meketa Investment Group Inc. and specialty hedge fund consultant Cliffwater LLC to find "ways to manage risk better," said Kristen Santos, retirement plan administrator, in an interview.

"Having so much in equities keeps me awake at night," Ms. Santos said, noting that while "volatility has been oddly low, we expect it will be back and trustees approved the addition of the volatility hedge fund to help mitigate that risk."

Asset owners are seeking help from New York-based Neuberger Berman to find a lower-volatility defensive equity strategy, said Douglas Kramer, co-head of quantitative and multiasset class investments.

"The big question is whether the markets will continue to be up over 10% over the next three to five years. The one thing everyone had to own was equity beta, but at the end of a nine-year equity market, investors are wondering what to do when volatility is up and equity beta isn't as good as it used to be. They want equity risk with lower volatility," Mr. Kramer said.

"The pipeline is pretty full," Mr. Kramer admitted, noting the firm’s Equity Index PutWrite strategy has already attracted inflows, with assets in it and a companion mutual fund growing 185% to $3.7 billion in the 18 months ended June 30.

Most investors in the PutWrite strategy substitute it for existing low-volatility or defensive allocations or as a cheaper substitute for long/short equity hedge funds, Mr. Kramer said.

Neuberger Berman manages a total of $304 billion.

More receptive

Volatility managers said investment consultants who advise institutional investors are becoming more receptive to the addition of derivative-based volatility management strategies in institutional portfolios.

"Consultants have really come around to the idea of incorporating options-based strategies over the last 18 months," said Dennis M. Davitt, partner, portfolio manager and head of Americas derivatives risk and trading, Harvest Volatility Management LLC, New York.

Consultants' willingness to consider volatility strategies has contributed to the firm's "full and growing" new business pipeline, Mr. Davitt said.

The firm already has had success in attracting institutional and ultra-high-net-worth clients and registered investment advisers. Compound-annualized growth in the firm's options-based strategies has been 23% over the past five years to $12 billion as of June 30, said Curtis F. Brockelman Jr., the firm's managing partner.

The key to that success has been consistent education and consultative advice to investors about the use of volatility strategies in portfolios, Mr. Brockelman said.

"We've taken a very complex derivative investment approach and made it simpler to increase yield, protect against downside risk and add diversification," Mr. Brockelman added.

Mr. Davitt called volatility "the enemy of compounded returns," and stressed that the firm's willingness to customize its hedged equity and risk-premium equity strategies to meet specific needs of individual clients. "We are all ears," he said.