Almost all investors conceptually understand the benefits of diversification and agree with the saying, “Don’t put all your eggs in one basket.” As a result, investors typically diversify unsystematic risk quite well within specific asset classes. However, from a broader perspective, their asset allocation is still heavily dominated by stocks and bonds, and they are often reluctant to include other alternative or unusual assets in their asset allocation.
However, building a truly diversified portfolio involves combining investments that behave differently or that statistically have a negative or low correlation. Unfortunately, investors often do not fully exploit the potential of diversification and get caught in what we call the diversification illusion: They tend to add components to their asset allocation that are often a blend or simple transformation of what they already have. In fact, private equity, high-yield credit, real estate, and mortgages are just blends or slightly transformed versions of stocks and bonds, i.e., assets that, like stocks and bonds, benefit from growth and falling interest rates.
That being said, there are other types of investments that are much more useful in terms of diversification, but unfortunately are often dismissed or underestimated. In our opinion, one of the most underestimated investments is Active Long Volatility.
Active Long Volatility describes investment strategies that seek to opportunistically profit from turbulence while trying to minimize costs by acting as a “smart” insurance policy against major volatility spikes. This approach is similar to that of a defensive player or goalkeeper in a team sport, whose value comes from avoiding losses rather than scoring points. Usually, Active Long Volatility strategies take advantage of a rise in volatility by buying options and/or VIX futures contracts.
The main added value of Active Long Volatility is its anti-correlation with the economic and growth cycles and its explosive performance during market crises. Compared to traditional hedging solutions, Active Long Volatility forgoes continuous protection in favor of more dynamic protection to reduce costs. Consequently, Active Long Volatility is designed to benefit from significant market downturns, volatility clusters, or prevailing trends.
Note that the word “Active” plays a key role here. This is because passive exposure to long volatility is a real return killer and simply eats up the returns an investor earns by investing in risky assets such as equities.
Thus, the distinctive feature of Active Long Volatility strategies is that they can provide cost-effective anti-correlation to growth or equity risk premium and low correlation to bonds (duration).
Intuitively, the goal is to make market crash insurance Pareto-efficient: Paying only 20% of the insurance premium while being protected against 80% of the impact of a crash. By analogy, this is like paying for car insurance only when it is raining, the road is bumpy, and there is a lot of traffic.
The first reason is probably simply that Active Long Volatility investments are not easily accessible to investors and often require the ability to invest in rather exclusive hedge funds. As a result, such investments tend to be available only to very sophisticated and ultra-wealthy investors.
To address this lack of accessibility, Alquant has decided to democratize Active Long Volatility and allow more investors to profit from such investments by launching its own Active Long Volatility strategy called Alvola. Alvola is packaged in a Swiss ISIN and is available to any qualified investor*, without any lock-in periods and significantly lower barriers to entry than similar solutions.
The second reason is related to the “diversification illusion.” Although investors claim to have understood the benefits of diversification, they still place too much emphasis on the excess returns and individual performance of each strategy or asset, and not enough on low or negative correlation from the perspective of the overall asset allocation. This leads to suboptimal portfolio diversification.
The combination of investors’ obsession with performance and the fact that stocks and bonds have delivered impressive performance in recent decades probably explains why investors are concentrated in these asset classes and thus suffer from the “diversification illusion.”
In this context, Active Long Volatility is often dismissed as a potential investment just because of its rather unimpressive standalone performance. Indeed, if we take the CBOE Eurekahedge Long Volatility Hedge Fund Index as a proxy for Active Long Volatility exposure, we could easily conclude that Active Long Volatility has not delivered great returns, especially over the past decade. Indeed, the chart below shows that ignoring the COVID-19 crisis, the index has consistently delivered negative returns over the past decade.
But let’s now examine what Active Long Volatility would bring in combination with an equity portfolio strategy. In this context, it turns out that Active Long Volatility greatly enhances the portfolio dynamics and acts like an airbag in tough situations.
In particular, adding Active Long Volatility to an equity portfolio reduces the drawdowns investors traditionally face during market downturns without reducing returns too much during bull markets, making the statistic particularly attractive: Compared to the S&P 500, the Sharpe ratio is improved and the maximum drawdown is reduced. Attentive readers will note, however, that this combination tends to weigh on returns, especially during prolonged bull markets, so that improving the overall risk-adjusted performance may cost a bit of absolute performance.
This is where Alquant comes into play. Alquant has developed a unique Active Long Volatility solution called Alvola. In addition to outperforming during market crashes, Alvola aims not to hurt investors’ returns during extended periods of rising markets. Thus, a portfolio containing Alvola has the ability to become safer and perform better over a full market cycle.
Author: Guillaume Bourquenoud
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