Investors adapting portfolios to volatile environment

Nearly five years after suffering the biggest investment losses of their careers, chief investment officers are hot on the trail of volatility management solutions.

They are seeking to protect their institutional investment pools from drastic drawdowns in the event of another financial crisis of the magnitude endured in 2008-2009 using a wide range of volatility protection measures.

Approaches range from less complex strategies such as well-diversified asset allocation formulas and low-volatility equity and fixed-income strategies, and extend to more intricate risk-parity and liability-driven investment approaches that limit equity-market risk, and overlay strategies that hedge risk synthetically through the use of derivatives.

Institutional investors using approaches to volatility management include:

• Air Canada, Montreal, for its C$10.9 billion (U.S.$10.6 billion) defined benefit plan;


• Colorado Fire and Police Pension Association, Greenwood Village, $3.5 billion defined benefit plan;


• The Dow Chemical Co., Midland, Mich., U.S. defined benefit plans totaling $12 billion;


• Fairfax County (Va.) Employees' Retirement System, $3.4 billion defined benefit plan;


• Healthcare of Ontario Pension Plan, Toronto, C$47.4 billion;


• Koch Industries Inc., Wichita, Kan., $5.4 billion defined benefit plan;


• PKA, Hellerup, Denmark, 200 billion Danish kroner ($36 billion) for five defined benefit plans; and


• University of Chicago, $6.5 billion endowment.

At its simplest, “volatility (management) is about management of extremes” and volatility management strategies focus on outcomes that control downside volatility or capture returns from active volatility trading, said Vincent de Martel, managing director, global market strategies at BlackRock Inc., based in San Francisco.

“Many investors find themselves in an interesting quandary,” said Michael Thomas, chief investment officer, Americas institutional, at Russell Investments, Seattle.

“They need a relatively high allocation to equity or equity-like beta to have any chance of meeting their return targets. Taking more risk to attempt to close the pension funding gap puts pension funds between a rock and a hard place and that's fatal tail risk. You have to take risk to get return, but it could kill you,” Mr. Thomas stressed.

Not using risk-based asset allocation methods led many institutional investors to build “naive, high-beta, high-risk, equity-centric portfolios” that were hammered in the 2008 financial crisis, said Andrea Frazzini, vice president, AQR Capital Management LLC., Greenwich, Conn.

“A risk-based approach is the antidote to plan sponsors who realized that they needed to build a better mousetrap,” Mr. Frazzini said, noting a diversified risk-parity strategy that uses leverage to amp up returns of low-beta stocks and other low-risk investments is a natural outcome of a risk-based allocation process.

“Institutional investors are coming around to the notion that they have to move to actively manage exposure to risky assets. These volatility-responsive strategies abandon target-weight asset allocation models in favor of managing to volatility targets,” Mr. Thomas added.

Quantifying institutional appetite for volatility management tools and strategies isn't possible, given the spectrum of possible solutions, but demand has been strong enough since the 2008-2009 market crash to have money managers scrambling to build investment strategies and in-house consulting/solutions teams, said David J. Bauer, partner at Casey, Quirk & Associates LLC, Darien, Conn., a consultant to investment firms.

“The challenge to wrapping your head around volatility management is that the area is so broad and every money manager in the industry claims they can and do control volatility,” agreed Russell Investments' Mr. Thomas.

The high level of interest from big institutional investors in dedicated volatility management strategies is creating a fair amount of hype in the investment industry, sources said.

“When second- and third-tier consultants call about the strategy, I get worried,” quipped Theodore R. Aronson, managing partner and a portfolio manager at AJO LP, Philadelphia, which manages about $1 billion in low-volatility equity strategies.

“I would say there is a bit of faddishness in this. After the financial crisis, there was huge interest in this, like it is a silver bullet,” Mr. Aronson said.

Fads notwithstanding, money managers report strong asset growth in their volatility management approaches.

Quantitative specialist Acadian Asset Management LLC, Boston, had $5 billion in various U.S. and non-U.S. managed equity volatility strategies as of Dec. 31, representing 150% growth in calendar year 2012, said Theodore “Ted” Noon, senior vice president and director of North American business development.

GAM USA Inc., New York, has seen assets managed in its unconstrained bond strategy — with target volatility of 3% and low correlation to both the Barclays Capital Aggregate Bond and the Citigroup World Government Bond indexes — double over the past three years to $15 billion, said Joseph F. Gieger, managing director-Americas.

AQR Capital Management has grown to become one of the largest risk-parity providers, having gone from zero to $25 billion since May 2006 when its first strategy launched, said David G. Kabiller, founding principal and head of business development.

Active volatility trading strategies are also gaining in popularity, sources said.

Pacific Investment Management Co., Newport Beach, Calif., offers an active volatility hedge fund strategy that seeks to generate alpha from trading volatility, that has had “incredible demand from institutional investors,” said Joshua Thimons, managing director and lead portfolio manager. Assets invested in the volatility strategy have doubled to $20 billion in the three years ended Dec. 31.

Capula Investment Management LLP, a London-based global fixed-income and macro hedge fund manager, has always managed both the downside and the upside volatility of the internally managed portfolios used in its multistrategy funds.

After the crisis of 2008-2009, the firm's institutional clients asked Capula's team if they could invest in the volatility trading strategy in order to make money from the market's extreme volatility.

“The requests were relatively reactionary, a way to profit from the debacle,” said Edward O'Reilly, partner and head of distribution-Americas, who is based in the firm's Greenwich, Conn., office.

The situation has “morphed” over the past year or two with institutional clients now asking Capula for assistance in reducing the volatility of their overall portfolios, expressing interest in Capula's defensive volatility management approaches, which include market neutral and relative value hedge fund strategies and the “residual beta” present in dedicated hedging strategies, managed futures and direct shorting, Mr. O'Reilly said.

Capula managed $10.5 billion as of March 1; the amount managed in volatility strategies was not available.

Russell Investments' managers-of-managers volatility-specific overlay strategies and volatility-responsive strategies have grown from zero to $5 billion each in the past two years, Mr. Thomas said.

Overlay strategies also are gaining in appeal among the institutional investor ranks.

NISA Investment Advisors LLC, St. Louis, for example, manages about $30 billion in derivatives associated with LDI strategies designed to limit funded status volatility and about $20 billion in equity overlay strategies, “many of which are designed to accomplish an overall asset allocation or mitigate specific asset class volatility,” said David G. Eichhorn, managing director, investment strategies, in an e-mail.

The growth in NISA's overlay strategies was not available.

NISA manages a range of strategies from long-bond allocations in liability hedges to equity option strategies designed to limit risk asset volatility.

In the “LDI space for example, we often see much larger allocations where both derivatives and physical fixed income play a significant role in the hedge,” Mr. Eichhorn wrote.

Investment consultants, by and large, advise their institutional clients to take a portfoliowide approach to volatility management along the lines of what NISA is crafting for some of its institutional investors.

“If you use risk budgeting to create a highly diversified portfolio, it's a much better, more humble starting place,” said Erik L. Knutzen, chief investment officer at consultant NEPC LLC, Cambridge, Mass.

A holistic approach to portfolio management would marry a diversified, risk-based model with embedded economic volatility hedging within the portfolio to protect against inflation, deflation and interest rate changes, Mr. Knutzen said. The addition of global macro strategies with flexibility to allocate dynamically across a wide range of economically sensitive securities would create a long-volatility sleeve with the potential to generate alpha.