Investing in volatility: a new frontier for traditional portfolio diversification€¦ · · 2014-12-15a new frontier for traditional portfolio diversification ... Conclusion 12

Investing in volatility: a new frontier for traditional portfolio diversification

www.seeyond-am.com AN EXPERTISE OF

Intended for professional clients as defined by the MiFID directive

SEEYONDVolatility management and structured product investment division of Natixis Asset Management

Over the past decade, financial markets have been shaped by the growing interconnexion between asset classes, the increasing frequency and magnitude of shocks, as well as the obvious exhaustion of market trends. Many investors believe that to generate performance in the medium to long term, relying on traditional asset management alone is no longer enough.To meet these new challenges and to offer investments that combine performance generation with risk reduction, Seeyond implements investment strategies that go beyond conventional active management.In order to turn uncertainty into opportunity, Seeyond develops a complete range of funds in 3 areas of expertise:- Structured Beta & Guarantee- Smart Beta- Flexible Beta & Volatility

The portfolio management team is daily supported by a quantitative research platform.

With 32 employees, Seeyond has €15.1 billion in assets under management as of 30/09/2014(Source: Natixis AM).

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Quantitative Research White Papers # 3

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# 3 Quantitative Research White Papers

CONTENTS

Introduction 5

Dissecting the environment helps better understand the limits 6 of traditional diversification

Pushing the boundaries of traditional portfolio diversification 9

Conclusion 12

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SUMMARY

Diversification is a cornerstone of investors' mindset. Recent developments in macro economic policies, broadly masterminded by the Fed, had shed light on the limits of diversification across equities & bonds. Our analysis shows that including equity volatility as an additional asset class can improve diversification by creating a source of risk mitigation. We show also that equity volatility allocation has to be actively managed in order to effectively improve diversification.

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3 month correlation of the S&P 500 and US Treasuries (LHS)

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INTRODUCTIONThe debate around the diversification benefits of combining traditional asset classes, inclu-ding stocks, bonds and cash has been pushed to the forefront in light of the recent market experience. The tapering announcement by the FED in June 2013 had effectively a negative impact on both stock and bond markets. This co-movement pushed up correlations, and outlined the issue related to the stability of correlations, and therefore cast doubts upon the potential diversification benefits. By considering the relationship between stocks and bonds over the past 25 years an observer can arrive at the conclusion that correlations are time varying (graph 1). History can certainly help identify some of the variables at work. However the ability to extrapolate future assumptions has its limits. Nevertheless identifying the different states of nature in which asset class returns vary in relation to one another provides useful information on how correlations react depending on economic conditions. This will be the starting point for our study as we explore the boundaries of traditional asset allocation and introduce a new investable source of diversification, namely equity volatility which has the ability to provide diversification specifically when other asset class returns tend to cluster around each other. Equity volatility demonstrates singular properties in terms of risk mitigation but can also offer a diversified source of return over the long term.

GRAPH 1 I CORRELATIONS VS INFLATION

Source: Bloomberg, between 30/09/1990 to 31/12/2013

As shown in graph 1 before 1998 correlations between stocks and bonds were positive and also demonstrated low volatility. This was strongly influenced by the relatively high level of inflation. After 1998 the Federal Reserve strived to harness inflation through applying the Taylor rule. The Taylor rule looked to set short term rates as a function of achieving the short term goal of stabilizing the economy and the long run goal for inflation. The consequence was that inflation’s influence on stock and bond correlations was significantly reduced as other factors such as monetary policy, the unemployment rate and the equity risk pre-mium began to take on greater significance. Correlation between stocks and bonds turned negative and became also more volatile in the process. It is therefore instructive to put the relationship between stocks and bonds under the microscope to identify the symptoms of changes of behavior over time.

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DISSECTING THE ENVIRONMENT HELPS BETTER UNDERSTAND THE LIMITS OF TRADITIONAL DIVERSIFICATION

When using the same observation period (1990 to 2013) to consider the relationship between equity market and bond market returns, 4 distinct states of nature can be identified and are summarized in the chart below.

GRAPH 2 I THE DIFFERENT STATES OF NATURE

Configuration 1 (stocks + and bonds -) is indicative of positive economic growth and a backdrop of increasing consumer spending. Both corporate earnings and valuations tend to be supportive and monetary policy tends to become more restrictive while aiming to control inflation and therefore having a knock on effect on rates and bond prices. There is little room for policy uncertainty and equity volatility tends to remain subdued.

CONFIGURATION 1 I SUMMARY TABLE

1 MONTH AVERAGE

STOCK MARKET PERFORMANCE +3.3%

BOND MARKET PERFORMANCE -1.2%

CORRELATION BETWEEN STOCKS AND BONDS -0.33

IMPLIED EQUITY VOLATILITY (VIX INDEX) % VARIATION -7.2%

INVESTIBLE IMPLIED EQUITY VOLATILITY (SPVXSP INDEX) PERFORMANCE -9.4%

Source: Bloomberg.

All data is based on daily observations between 31/12/1990 and 31/12/2013. Stock market data refers to the S&P 500 futures index. Bond market data refers to the futures 10 Year Treasury Note. The VIX index reflects a market estimate of future volatility for the S&P 500 index based on the implied volatilities for a wide range of options. The SPVXSP index measures the return from a daily rolling long position in short term VIX futures contracts traded on the CBOE.

Configuration 2 (stocks + and bonds +) is indicative of a recessionary period where finan-cing the economy has become an issue. In response monetary policy has become accom-modative and interest rates begin to decrease and in turn bond prices increase. Financing tends to become cheap and risk aversion generally diminishes which in turn can lead to an increase in risky asset prices. Uncertainty will tend to remain but potentially begin to subside.

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1 MONTH AVERAGE

STOCK MARKET PERFORMANCE +3.0%

BOND MARKET PERFORMANCE +1.3%

CORRELATION BETWEEN STOCKS AND BONDS +0.2

IMPLIED EQUITY VOLATILITY (VIX INDEX) % VARIATION -6.0%

INVESTIBLE IMPLIED EQUITY VOLATILITY (SPVXSP INDEX) PERFORMANCE -9.8%

Source: Bloomberg. All data is based on daily observations between 31/12/1990 and 31/12/2013. Stock market data refers to the S&P 500 futures index. Bond market data refers to the futures 10 Year Treasury Note. The VIX index reflects a market estimate of future volatility for the S&P 500 index based on the implied volatilities for a wide range of options. The SPVXSP index measures the return from a daily rolling long position in short term VIX futures contracts traded on the CBOE.

Configuration 3 (stocks - and bonds +) is indicative of an economic environment which is at risk of overheating. Investment growth and corporate earnings tend to decline. The level of uncertainty tends to increase along with risk aversion. Risky asset prices can decline and a flight to quality supports bond prices. The level of uncertainty generally remains high.


1 MONTH AVERAGE

STOCK MARKET PERFORMANCE -3.7%

BOND MARKET PERFORMANCE +1.7%

CORRELATION BETWEEN STOCKS AND BONDS -0.37

IMPLIED EQUITY VOLATILITY (VIX INDEX) % VARIATION 13.3%

INVESTIBLE IMPLIED EQUITY VOLATILITY (SPVXSP INDEX) PERFORMANCE 8.4%

Source: Bloomberg.All data is based on daily observations between 31/12/1990 and 31/12/2013. Stock market data refers to the S&P 500 futures index. Bond market data refers to the futures 10 Year Treasury Note. The VIX index reflects a market estimate of future volatility for the S&P 500 index based on the implied volatilities for a wide range of options. The SPVXSP index measures the return from a daily rolling long position in short term VIX futures contracts traded on the CBOE.

Configuration 4 (stocks - and bonds -) is illustrative of an environment where the economy is slowly recovering. Anticipations around potential interest rate tightening have a negative impact on bond prices. Corporate earnings are not sufficiently resilient to absorb higher financing costs and uncertainty tends to increase and stock prices decline. Uncertainty around monetary policy remains high.


Source: Bloomberg. All data is based on daily observations between 31/12/1990 and 31/12/2013. Stock market data refers to the S&P 500 futures index. Bond market data refers to the futures 10 Year Treasury Note. The VIX index reflects a market estimate of future volatility for the S&P 500 index based on the implied volatilities for a wide range of options. The SPVXSP index measures the return from a daily rolling long position in short term VIX futures contracts traded on the CBOE.

1 MONTH AVERAGE

STOCK MARKET PERFORMANCE -3.4%

BOND MARKET PERFORMANCE -1.3%

CORRELATION BETWEEN STOCKS AND BONDS +0.2

IMPLIED EQUITY VOLATILITY (VIX INDEX) % VARIATION 15.1%

INVESTIBLE IMPLIED EQUITY VOLATILITY (SPVXSP INDEX) PERFORMANCE 9.0%

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As shown in the tables above the relationship between equities and bonds changes over time and there are both transition periods where uncertainty remains high and the lack of visibility leads to risky assets correcting alongside bonds. Volatility in this instance provides access to a useful tool: namely a source of diversification when diversification has become a scarce resource.

GRAPH 3 I FREQUENCY OF THE DIFFERENT STATES OF NATURE OVER TIME

Source: Bloomberg.

All data is based on daily observations between 31/12/1990 and 31/12/2013. Stock market data refers to the S&P 500 futures index. Bond market data refers to the futures 10 Year Treasury Note.

The bar charts above provide greater insight around the different states of nature over time. Two configurations appear clearly on this chart since the early nineties. The lack of diversification benefits (states 2 and 4) dominated until 1999 within an inflationary context. Since then diversification opportunities have been prevalent (configurations 1 and 3) but have started to decline over the last 3 years. This pattern raises the issue of diversification among bonds and stocks during transitory periods.

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Stocks + / Bonds - (configuration 1) Stocks - / Bonds + (configuration 3)

Stocks + / Bonds + (configuration 2) Stocks - / Bonds - (configuration 4)

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PUSHING THE BOUNDARIES OF TRADITIONAL PORTFOLIO DIVERSIFICATION

In principle, volatility can potentially provide a source of diversification in periods of transition. It is therefore important to understand the benefits and drawbacks of investing in volatility, in addition to comparing volatility to other sources of potential risk mitigation such as cash. As shown in the chart below the integration of investable volatility (i.e. VIX futures) demons-trates that the cost of a structural exposure to short term volatility largely outweighs the benefits. The cost of carrying volatility is an expensive insurance premium which not only dampens risk within a diversified portfolio but also dampens return to a greater extent.

GRAPH 4 I INTEGRATING VOLATILITY PASSIVELY WITHIN A DIVERSIFIED PORTFOLIO OF STOCKS AND BONDS

Integrating cash as a structural asset class within a portfolio of stocks and bonds could also provide an investor with greater diversification and more attractive risk adjusted returns. We have thus compared utilizing cash versus investing in volatility to push out the diver-sification frontier. The ability to buy or sell volatility provides the potential to exploit the latter as a source of risk mitigation while at other times using volatility as a diversified source of return. Considering a naive approach to volatility is therefore an interesting starting point. It consists in going long or short volatility, on a binary basis, depending on the states of nature (configurations 1, 2, 3 and 4) i.e. buying volatility in periods of uncertainty and, conversely, selling volatility in normalized conditions to harvest the premium. An advanced approach would be to consider implementing an active strategy by dialing up and down our exposure to volatility more gradually and exploit specific features of volatility, including mean reversion1 and momentum.

1. Volatility has a tendency to revert towards its long term average

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60/40 represents 60% equities and 40% bonds. 48/32/20 represents 48% equities, 32% bonds and 20% short term VIX futures. Analysis covering the period from end of December 1990to December 2013 is based on daily returns of the S&P 500 futures, the futures 10 Year Treasury Note and the SPVXSP Index.

Source: Bloomberg.

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Here below we show simple efficient frontiers for each of those portfolios and strategies:

➜ D represents a set of diversified portfolios of stocks and bonds.

➜ N illustrates a set of diversified portfolios of stocks and bonds with a 20% constant allocation to the naive volatility strategy relying on short term VIX futures. The flexible allocation rule consists in going short VIX futures when configurations 1 or 2 prevail while going long VIX futures in configurations 3 and 4.

➜ C consists of a set of diversified portfolios of stocks and bonds with a 20% constant investment in cash.

➜ A represents a set of diversified portfolios of stocks and bonds with a 20% constant allocation to the advanced volatility strategy with VIX futures. This strategy consists in gradually transitioning from long to neutral and neutral to a short VIX futures posi-tion depending on momentum. Short positioning strives to benefit from volatility decay (the mean reversion effect) or from the volatility premium (cost of carry). Long positions aim to exploit upward volatility movements.

GRAPH 5 I EFFICIENT FRONTIER ANALYSIS OF COMPARATIVE PORTFOLIOS

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D N C A

Source: Bloomberg.

All data is based on daily observations between 31/12/1990 and 31/12/2013. Stock market data refers to the S&P 500 index. Bond market data refers to the 10 Year Treasury Note. Both the Naive volatility strategy (N) and the Advanced Volatility strategy (A) integrate short term VIX futures illustrated by the SPVXSP index. The SPVXSP index measures the return from a daily rolling long position in short term VIX futures contracts traded on the CBOE.

The benefits of adopting a flexible approach to volatility management become clear within the context of a diversified portfolio and pave the way to introduce equity volatility as a durable source of diversification. Another way to consider the impact of volatility investing is to apply the same analysis and observe the outcome for risk adjusted returns.

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GRAPH 6 I SHARPE RATIO ANALYSIS OF COMPARATIVE PORTFOLIO

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Source: Bloomberg.


The chart above demonstrates the consistent superior risk adjusted returns derived by the integration of equity volatility as an asset class in comparison to both a diversified portfolio of stocks and bonds and also a portfolio of stocks, bonds and cash. The calendar year returns are shown here below also for illustrative purposes and highlight the limits of a naive approach to volatility (i.e. 2007 and 2008 for instance).

GRAPH 7 I CALENDAR YEAR RETURNS OF COMPARATIVE PORTFOLIOS

Source: Bloomberg.


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CONCLUSION

"Past performance is no guarantee of future results": this is a statement that every investor is generally familiar with. Today we could be at a crux, with historical relationships between asset classes no longer having future application. An unprecedented amount of artificial stimulus has been provided by central banks to prop up economies across different regions. This in turn has led to historically low interest rates. However a certain amount of uncertainty remains around monetary policy and future growth prospects around the globe. Financial markets are by definition uncertain however everywhere one looks that level of uncertainty seems to be increasing.

Traditional asset allocation approaches have been called into question as the relationship between stocks and bonds is increasingly volatile and the negative impact of rising rates could potentially limit the diversification power of bonds within a global allocation. A first answer to overcome that hurdle would be to adopt a flexible approach to weathering short term volatility by adjusting capital allocation dynamically over time while resorting to a broad multi-asset investment universe. Heightened global market volatility over the last decade has fuelled greater interest in seeking investments that are less correlated to traditional equity markets or fixed income markets. These types of strategies are commonly referred to as global tactical asset allocation. However such approaches tend to benefit most when visibility is high and allocation decisions among asset classes can be made.Interestingly, equity volatility represents an investable asset class which is geared towards generating value in periods of transition, specifically when traditional asset classes lack visibility and are the most challenged. We therefore strongly believe that integrating actively managed equity volatility within a global portfolio provides a durable source of diversification.

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DISCLAIMER

This document is intended for professional clients as defined by the MiFID. It may not be used for any purpose other than that for which it was conceived and may not be copied, diffused or communicated to third parties in part or in whole without the prior written authorization of Natixis Asset Management.No information contained herein shall be construed as having any contractual effect. This document is produced purely for informational purposes. It constitutes a presentation conceived and created by Natixis Asset Management from sources that it regards as reliable. Natixis Asset Management reserves the right to change the information in this document at any time and without notice. Natixis Asset Management may not be held liable for any decision taken or not taken on the basis of information contained in this document, or for any use of this document that may be made by a third party.The figures provided refer to previous years. Past performance is not a reliable indicator of future performance.References to a fund’s ranking, price or rating offer no indication as to future performance.The analyses and opinions referenced herein represent the subjective views of the author(s) as referenced, are as of the date shown and are subject to change. There can be no assurance that developments will transpire as may be forecasted in this material.

This material is provided only to investment service providers or other Professional Clients or Qualified Investors and, when required by local regulation, only at their written request. • In the EU (ex UK) Distributed by NGAM S.A., a Luxembourg management company authorized by the CSSF, or one of its branch offices. NGAM S.A., 2, rue Jean Monnet, L-2180 Luxembourg, Grand Duchy of Luxembourg. • In the UK Provided and approved for use by NGAM UK Limited, which is authorized and regulated by the Financial Conduct Authority. • In Switzerland Provided by NGAM, Switzerland Sàrl. • In and from the DIFC Distributed in and from the DIFC financial district to Professional Clients only by NGAM Middle East, a branch of NGAM UK Limited, which is regulated by the DFSA. Office 603 – Level 6, Currency House Tower 2, P.O. Box 118257, DIFC, Dubai, United Arab Emirates. • In Singapore Provided by NGAM Singapore (name registration no. 5310272FD), a division of Absolute Asia Asset Management Limited, to Institutional Investors and Accredited Investors for information only. Absolute Asia Asset Management Limited is authorized by the Monetary Authority of Singapore (Company registration No.199801044D) and holds a Capital Markets Services License to provide investment management services in Singapore. Registered office: 10 Collyer Quay, #14-07/08 Ocean Financial Centre. Singapore 049315. • In Hong Kong Issued by NGAM Hong Kong Limited. • In Taiwan: This material is provided by NGAM Securities Investment Consulting Co., Ltd., a Securities Investment Consulting Enterprise regulated by the Financial Supervisory Commission of the R.O.C and a business development unit of Natixis Global Asset Management. Registered address: 16F-1, No. 76, Section 2, Tun Hwa South Road, Taipei, Taiwan, Da-An District, 106 (Ruentex Financial Building I), R.O.C., license number 2012 FSC SICE No. 039, Tel. +886 2 2784 5777. • In Japan Provided by Natixis Asset Management Japan Co., Registration No.: Director-General of the Kanto Local Financial Bureau (kinsho) No. 425. Content of Business: The Company conducts discretionary asset management business and investment advisory and agency business as a Financial Instruments Business Operator. Registered address: 2-2-3 Uchisaiwaicho, Chiyoda-ku, Tokyo.• In Latin America (outside Mexico) This material is provided by NGAM S.A. • In Mexico This material is provided by NGAM Mexico, S. de R.L. de C.V., which is not a regulated financial entity or an investment advisor and is not regulated by the Comisión Nacional Bancaria y de Valores or any other Mexican authority. This material should not be considered investment advice of any type and does not represent the performance of any regulated financial activities. Any products, services or investments referred to herein are rendered or offered in a jurisdiction other than Mexico. In order to request the products or services mentioned in these materials it will be necessary to contact Natixis Global Asset Management outside Mexican territory.

The above referenced entities are business development units of Natixis Global Asset Management, the holding com-pany of a diverse line-up of specialised investment management and distribution entities worldwide. Although Natixis Global Asset Management believes the information provided in this material to be reliable, it does not guarantee the accuracy, adequacy or completeness of such information. Document written on December 2014.

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Investing in volatility: a new frontier for traditional portfolio diversification€¦ · · 2014-12-15a new frontier for traditional portfolio diversification ... Conclusion 12