Over the past 36 months, the U.S. equity markets have displayed an almost zen-like ability to shrug off bad news, be it the turmoil in Greece or the collapse in energy prices; events that in other eras might have set Wall Street ablaze. This cocoon of contentment, however, was ripped open in late August, when observers of U.S. equity markets were offered a painful reminder of what volatility looks — and feels — like, as the Dow Jones industrial average suffered its largest ever three-day loss, attributable to worries over sustained economic weakness in China.
Even as the U.S. markets recouped much of their losses in the ensuing trading sessions, this skittishness was not altogether unexpected. As any seasoned options trader well knows, volatility has proven itself to be the most “mean-reverting” measure in finance, a fact that when coupled with movement in key gauges tracking volatility, might signal a renewed and persistent level of excitability that the market has not experienced in some time.
As volatility can wreak havoc on asset allocations, portfolio managers — even in sanguine conditions — struggle to find the elusive combination of performance and stability. And this mandate only becomes more acute as the equity markets assume a more flappable and less predictable trajectory.
Today, however, investors — through alternative funds — have at their disposal strategies that can benefit from the growing perception of risk in the markets that sets in motion the wild swings in equities, such as those witnessed in August and early September.
These volatility strategies, when viewed as their own discrete asset class, are designed with the goal of delivering returns that are in line with historical assumptions for equities while maintaining a far narrower range of performance (i.e., a substantially higher Sharpe ratio) and downside protection that can limit losses. Moreover, in a market in which yield has become difficult to find, the construct of equity buy/writes, coupled with bottom-up fundamental analysis, can create a synthetic yield instrument that delivers uncorrelated returns and manages to capitalize on volatility rather than being subjected to it.