What’s next for volatility investing?

Despite some negative headlines about volatility investing after the violent market sell-off in March, plan sponsors shouldn’t write off volatility investing altogether because it can be a valuable investment tool if used appropriately, said Seth Weingram, senior vice-president and director of client advisory at Acadian Asset Management, when speaking at the Canadian Investment Review’s Investment Innovation Conference in November.

There are three common pitfalls in volatility investing: the mismanagement of explosive payoff strategies, failures of imagination in risk management, and having structural blind spots about the workings of particular strategies or the options market itself, he said.

The increasing popularity of volatility investing comes with the worry that along with ease of access, investors will not realize the importance of domain knowledge. “That will lead to disappointing investment outcomes, overlooked opportunity and frankly more headlines,” he said. “And that’s in part because the options market really has a distinctive nature that’s different from other markets that investors tend to be familiar with. Specifically, it’s not a matching engine. It doesn’t simply connect end investors who want to buy and sell the same instruments. Instead, it functions as a complex risk redistribution machine.”

Particularly, he highlighted the special role of options dealers and the fact that the options market has different types of end investors that use particular types of options. “Some, for example, trade only short-term listed options on individual equities, while others only use long-term index options through investments in structured products. Now what this means is that the number and nature of market participants varies considerably across options’ underlyings, across strikes and across maturities. And therefore, so does the balance of supply and demand.”

It’s key for pension plans to understand the characteristics of the market because it will help them understand the compensation available for return-seeking strategies and the cost of protection, Weingram noted.

With these common pitfalls in mind, Weingram highlighted three elements for well-conceived volatility investing approaches: having a combination of return-seeking and protective elements, adopting to changing market conditions and market structure, and implementing tail-sensitive and forward-looking risk management.

Specifically, combining long and short elements in a strategy more fully leverages variation in supply and demand across the options market to gain return premia when it’s attractive, and protection when it’s inexpensive, Weingram said, noting it also provides greater flexibility to optimally trade off tail exposure against available premium as market conditions change.

Further, simple smart beta or alternative risk premia approaches tend to embed rigid positioning. “Instead, net positioning in volatility should be responsive to the pricing environment. Seen through a systematic lens, that means evolving signals related to investor risk aversion, liquidity conditions, the cost of carrying positions. As well, the choice of implementation should be informed by longer-term trends and developments in both product development and regulation.”

Weingram advocated for volatility and options budgeting and position sizing that is based on their contributions to overall portfolio tail risk. “In doing so, the risk scenarios you consider should be informed by product characteristics and market knowledge and they should not be limited to recent historical experience.”

Overall, investors shouldn’t come out of 2020 thinking volatility investing is unavoidably dangerous, Weingram said. “But the 2020 headlines do underscore that volatility investing is an especially poor venue for rudimentary and mechanical implementation. Volatility investing and options are domains where market knowledge and nuance are essential.”