June 11th 2021  

Markets

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.

Confidentiality Notice and Disclaimer

This is an investment idea and advertising material, not an advice or a solicitation. Access to this information is forbidden to persons in any jurisdiction where the publication of or access to the Alquant Platform and Website would result in a violation of any applicable law or regulation (by way of domicile, residence, nationality, investor status, or otherwise). Alvola is only suitable for qualified investors. Past performance is no guarantee of future results.

It is for information purposes only and does not explicitly target any person who by domicile or nationality is prohibited to receive such information according to applicable law.

While ISP Group Ltd. uses reasonable efforts to obtain information from sources which it believes to be reliable, ISP Securities Ltd. makes no representation or warranty as to the accuracy, reliability or completeness of the information. Unless otherwise stated, all figures are unaudited.

 

This document is neither an offer or solicitation nor a recommendation or advertisement for the purchase or sale of financial products or financials services and does not discharge the recipient from his own judgment.  The development of the values mentioned in this document originates in the past. Past performance is no guarantee for future performance. Each investment bears risks, such as value and profit fluctuations. Investments in foreign currencies may be subject to currency exchange rates.

Particularly, ISP Group Ltd. recommends that the recipient, if need be by consulting professional guidance, assess the information in consideration of his personal situation with regard to legal, regulatory and tax consequences that might be invoked.

None of the information contained on this document constitutes financial advice or analysis within the meaning of the Swiss Bankers Association's Directives on the Independence of Financial Research.


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