Volatility is forecastable, but is also volatile. It also expires, and even experts would have to spend at least a couple of per cent a year paying for the positions they would choose to take. In one way, investing in structured products, or even equities is a way of buying volatility, but most investors do not look at it that way, according to a panel speaking at SRP Americas on June 17 at The Rever Hotel in Boston.
"People are concerned with two things: unexpected changes in volatility, and big moves in markets," said Paul Mende (pictured), senior lecturer, Finance Group, MIT Sloan School of Management. On the plus side, the market has moved on, and there "is a lot of good technology for predicting, over long and short horizons, how volatility behaves; that it tends to be persistent over periods; when it jumps up, it tends to stay high, and this gives a lot of tools for investors, " said Mende.
"We used the forecasts to not bet on things. By being forecastable, volatility is also hedgeable," said Mende. "Our starting position with everything was, be neutral: if there is a risk factor, why not be neutral.
According to Mende, when you buy a strong product, you are generally long volatility without knowing it. "Anyone who has an option, or any floor or price guarantee is long an option and long volatility," said Mende. "When the market crashes and the protection kicks in: people don't usually think, 'that's great, I had a great investment, I was long vol', any more than they do when their car gets into an accident and they have insurance, but that's part of it."
More of a concern are the products created that are specifically very short volatility: these products need to be really explicit and matched up with what investors need, said Mende.
The starkest change in volatility came in the wake of the financial crisis, when bank liquidity disappeared, said Yevgeny Frenkel, managing director, asset & wealth management, 1Oak Group. "The market was very different before 2008, because it was very liquid," said Frenkel. "First, there was a group of market makers, large banks with trillion-dollar balance sheets that all stood ready in times of dislocation, and would come into the market and normalise it. They put their capital to work; they saw it as an opportunity; more than that, they saw it as an obligation, to keep orderly markets."
According to Frenkel, since 2008, these banks have become skittish about using their balance sheets as well as more regulated, so liquidity shifted to high-frequency trading and private hedge funds that feel no obligation whatsoever to maintain orderly markets. "They are in it to make a profit," said Frenkel, adding that although the volatility world used to be more orderly and based around some kind of predictable outcomes, now it is less predictable in terms of the macro-environment
"Things that were impossible have become an everyday occurrence, with a widening of outcomes," said Frenkel. "The implication for investors is, it is very difficult to hedge: there are two distributions and no liquidity in between. "So, volatility will be higher, structurally, and it is very low when markets are orderly - with Quantitative Easing - but then it spikes dramatically, and markets stop being orderly."
According to Frenkel, it is very difficult to manufacture a hedge that is not an explicit buying of options before. "People react by taking smaller positions," said Frenkel. "It is not easy to hedge big portfolios, and it is not cheap."
While the US Federal Reserve was once a mover and a shaker in the volatility of financial markets, those days are gone, according to Frenkel. "The Fed decision does not matter anymore, starting this year," said Frenkel. "People have come to realise that rates are low globally. Interest volatility used to drive everything; right now, it is not an indicator of risk premium, because the Fed has taken all risk premium out of rates, so the volatility you need to look at is more Vix, and the best way to look at that is not as a headline number, but as a yield. You want to see steep volatility curve to think that things will get better. It is more of a relative value shift in volatility. You need to see yields going higher for volatility to drop off."
For some products, "the goal is to provide a stability in returns," said Jung Peel, director, investments, Navian Capital. "We are looking at solutions which can provide capital protection, leverage, yield. These are some of the solutions provided by the vol control and risk targeted indices.
"There are two ways to look at a capital-protected structured notes: one is on the structured side, which is getting very simple; and the second is underlyings, and volatility is a tool we can use with these to provide the type of products retail products may be interested in. For example, for a lot of the S&P-lined indices, there is a way to take a broad-based benchmark and provide a low volatility version of that, or pair that with cash to provide a risk-controlled type of index.
When you are lowering volatility or creating a vol targeted index, the options are much cheaper, which means you are able to offer products with a leveraged feature or a simple, point-to-point payoff," said Peel. "Many of these are created using historical measures of volatility, although we are seeing blended volatility measures, or even expected volatility measures, that still have the aim of providing stability in returns."
For Peel, investors do understand at least this, simplest version of volatility. "It is just taking a base index and pairing it with cash," said Peel
However, Mende pointed that "almost all of these ideas are complex".
"The approach just mentioned is simple, people understand insurance; two moving parts might be simple. Linear payouts and linear exposures are alright, and people understand a simple, one-sided exposure with insurance," said Mende.
Furthermore, investors want downside protection; and they also want some capital allocation, "which is leveraged/financed at a good rate (the implicit rate, using options to get leverage, you get to borrow at the riskfree rate, which investors otherwise don't have access to. In terms of yield, people need to be realistic: covered calls might be OK," said Mende. "Most people are buyers of car insurance, not sellers of car insurance to reckless drivers."
"People understand things; it would be nice if they understood more," said Mende.
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