Democratizing the missing portfolio component: Active Long Volatility

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.

The diversification illusion

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.

What 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.

 

 

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