Cs turbulence

Risk-oriented investment strategies – investment conceptwith volatility limit

Volatility as an effective control parameter in turbulentmarkets

1. New conditions on the financial markets call fornew investment concepts

Unpleasant correction phasesA “normal” market environment is characterized by a generally tolerable return fluctuation range(i.e. return volatility) accompanied by relatively low correlations between individual marketsegments. Under such market conditions, balanced portfolio diversification is an efficientinvestment approach. Amid steady return prospects, a sensible combination of individual assetcategories and asset classes reduces overall portfolio risk.

But if elevated uncertainty and sustained selling pressure prevail on the markets, portfolio riskcan jump sharply without the allocation of riskier assets such as stocks or foreign-currency-denominated bonds having been raised. This is illustrated, for example, by the return fluctuationsand thus volatilities recorded during the periods from mid-2008 to mid-2009, from May to June2010 and from August to September 2011, which hit readings far above the historical averagein some cases.

Asset ManagementApproved for global distribution

January 2013 White Paper

1/10Risk-oriented investment strategies – investment concept with volatility limit

Contents

1. New conditions on the financial

markets call for new investment

concepts

2. Overview of investment

concepts

3. Volatility-limiting investment

concept in detail

4. Glossary

René Küffer

Global Head iMACS

Risk-oriented investment concepts offer distinct advantages during marketcorrectionsExperiences from the past five years have shown that a classical investment approachlinked to a benchmark is not ideal in every market environment. For instance, duringperiods of elevated uncertainty and sustained selling pressure on the securities markets,portfolio risk, and thus loss potential, can increase sharply without the allocation of riskyassets having been raised. This effect can cause sleepless nights, especially for cautiousinvestors with high sensitivity to risk or losses.

In order to avoid such stress phases, an active asset management strategy focused onlimiting losses can present a very effective alternative. Two solution approaches presentthemselves here: the by now established capital protection concept and the comparativelylesser known investment concept that employs a volatility limit. Whereas the first approachsets a floor that the portfolio’s maximum loss in value cannot exceed, the secondapproach sets a ceiling for the portfolio’s maximum volatility.

Thomas Isenschmid

Head Client Portfolio Managers

iMACS


Figure 1 tracks the evolution of the weekly volatility of the S&P 500 stock index. Although thevolatility normally ranges between 10% and 30%, it broke out of that range during theaforementioned stress periods. In late 2008 it even spiked to a reading of 80% – i.e. a level threeto four times higher than the average fluctuation range – within the span of just a few weeks. Duringthose stress periods, the S&P 500 stock index was susceptible to much stronger fluctuations thanit is in a normal market environment. The probability of suffering a substantial loss in value on abroadly diversified portfolio thus increased considerably without the allocation of risky assets havingbeen changed.

Figure 1: Evolution of S&P 500 stock index volatility

Last data point: 28 December 2012Source: Credit Suisse. For illustrative purposes only.

Remedy in sight?Although the financial and debt crisis appears to be under control, it has by no means been resolvedyet and is likely to continue to subject the markets to repeated stress tests in the years ahead. Sothis raises the question of whether there are investment approaches that can control and reduceportfolio losses, particularly during stress periods. Because one thing seems certain: severe marketcorrections cause nervousness among many private and even professional investors. The longer-terminvestment horizon that is advocated during calm and objectively rational periods on the securitiesmarkets quickly gives way to an impulsive near-term mindset whose paramount goal is to avoid allfurther losses.

Professional (active) asset management involves various investment concepts. For example, it ispossible to draw a distinction between the following approaches: the classical benchmark-oriented concept; risk-oriented concepts.

The benchmark-oriented concept reduces overall portfolio risk through balanced diversification. Theexpected market trend is taken into account by overweighting or underweighting individual assetcategories and asset classes in accordance with the Investment Committee’s market and investmentviews. The goal is to outperform the market by employing tactical decisions. Ultimately, though, theportfolio largely remains subjected to market fluctuations.

Risk-oriented concepts enable the portfolio to profit from rising markets, but at the same time providea certain degree of protection against substantial losses in value. So compared to the benchmark-oriented concept, risk-oriented concepts offer a highly attractive additional dimension for investors whohave above-average sensitivity to risk or losses.

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Volatility index (VIX)Average fluctuation range

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Figure 2: Benchmark- and risk-oriented investment concepts

Source: Credit Suisse. For illustrative purposes only.

2. Overview of investment concepts

Benchmark-oriented concept (also known as the classical or relative-value concept)This investment solution orients itself toward the longer-term performance of the financialmarkets. Its goal is to replicate a market portfolio that is broadly diversified across a variety ofasset categories and to earn an excess return through active portfolio management. The basis ofthis approach is the long-term investment strategy (the strategic asset allocation or benchmarkweighting) devised in accordance with the investor’s risk profile and return expectations. Butdepending on the Investment Committee’s market expectations and investment views, individualasset categories will be overweighted or underweighted (tactical asset allocation) while adheringto set deviation bandwidths. For example, when stock markets are falling, the equity allocationcan be scaled back but cannot be completely reduced. Under active portfolio management,tracking error, which measures the deviation between the tactical allocation and the strategicallocation, is used as the main control parameter.

Portfolio risk is predetermined via the strategic asset allocation. However, as explained earlier,portfolio risk can rise substantially during market phases fraught with elevated uncertainty andsustained selling pressure. Moreover, in such an environment, the correlation between thedifferent asset categories and asset classes often increases because mounting psychologicalpressure causes investors to tend to sell off risky assets relatively indiscriminately. This reducesthe effect of diversifying risk, which additionally ratchets up portfolio risk and thus loss potential.Consequently, the portfolio can suddenly exhibit an undesired aggressive risk profile without thelong-term investment strategy ever having changed. However, market corrections sooner or laterare followed by a movement in the opposite direction. Such rebounds reduce portfolio risk, andthe investor can profit from some substantial price gains particularly on riskier assets (providedthat he or she withstood the psychological pressure and did not divest them).

This investment solution is feasible for investors who are willing to accept a certain degree offluctuation in the value of their assets. The magnitude of the fluctuations varies in accordancewith the investor’s specific risk profile and the corresponding mix of asset categories. The higherthe allocation of more aggressive asset categories, the longer the investment horizon should bein principle.


Benchmark-oriented Risk-oriented

Diagram ofperformanceover marketcycle

Investment focus Aimed at a predefined investment strategy Aimed at avoiding or reducing losses.

Active portfolio management based on the Investment Committee’s market expectations and investment views. The loss limit is monitored and adhered to by reducing investment risk if the portfolio approaches the loss or volatility limit.

Investment goal Outperformance of a designated benchmark. Limitation of loss potential in the event of substantial market corrections. Maximization of investment return in a normal market environment.

Investment style Active porfolio management based on theInvestment Committee’s market expectationsand investment views.

Ret

urn

Market

Relative return

Time

Ret

urn

Market

Time

Smoothedreturn

Risk-oriented conceptsAs mentioned earlier, risk-oriented concepts were developed for investors who have elevatedsensitivity to risk or losses. They are designed to enable investors to profit from rising markets,but are also designed to provide a certain degree of protection against substantial losses in valuein the event of protracted market corrections. For this purpose, the investor sets a loss orfluctuation limit that the overall portfolio is not allowed to exceed.

The limit can be set in two ways: Determination of a value loss floor for the overall portfolio (absolute loss limitation). Determination of a ceiling for portfolio volatility (relative loss limitation).

Like the benchmark-oriented concept, risk-oriented investment concepts start off with activeportfolio management. Using the Investment Committee’s market expectations and investmentviews as a basis, the aim is to seize market opportunities in order to maximize the return oninvestment. This means that with due regard paid to the investment strategy geared to the investor’srisk profile, riskier assets can definitely be included in the portfolio and can even be assigned asubstantial weighting. Additionally, though, the loss limit set by the investor – regardless of whetheran absolute or relative loss limitation – has to be taken into consideration at the portfolio level. Ittakes on central importance when the financial markets correct sharply (if an absolute loss limitationhas to be adhered to) or when volatility on the markets climbs to an above-average level (if a portfoliovolatility cap has to be complied with). If the portfolio value or portfolio volatility approaches thisbarrier, the portfolio manager is compelled to reduce risk in order to adhere to the limit. If themarkets relax and the portfolio value or portfolio volatility returns to a comfortable distance from theset limit, risk positions can gradually be built back up again in order to capture market opportunities.Since the markets first have to calm down before exposure to riskier assets can be ratcheted upagain, the investor “misses out” on the first stage of the recovery following the trend reversal. Buton the other hand, the investor’s losses were effectively contained during the preceding correctionphase.

Risk-oriented concepts are not devoid of risk because the investor remains invested in the financialmarkets, but they do reduce losses. And they offer an additional attractive aspect from a longer-term investment perspective. If an investor suffers less losses during severe market corrections, ina favorable environment less risk has to be taken to compensate for those losses. Risk-orientedsolutions thus limit losses in bad times and alleviate performance pressure in good times.

If the loss limit is defined as a value loss floor for the portfolio, this is actually an investment conceptwith capital protection. If the desire is to keep portfolio volatility under control, this has to do with avolatility-limiting concept. Both approaches are outlined below.

Capital protection (or floor) conceptThe aim of this concept is to generate a positive absolute return and at the same time to ensurecapital protection, with the investor accepting limited loss risk. To protect capital, the investor setsa bottom boundary or floor that defines the maximum allowed loss in the portfolio’s value(absolute loss limitation). The floor is geared to the investor’s risk profile and can be adjusted asneeded. It is usually raised as the portfolio’s value increases.

The portfolio manager safeguards adherence to the floor while taking into account a wide arrayof risks such as credit, issuer and liquidity risk, for example (as well as equity risk if this assetcategory is even taken into consideration at all given its comparatively high volatility). If the valueof the portfolio approaches the floor, risk must be gradually scaled back. Since the leeway for aloss in value is normally relatively small (i.e. the floor is set just a few percentage points belowthe initial portfolio value), the floor is treated as the main parameter guiding the management ofthe portfolio in any market environment. Apart from that, the management of the portfolio isbased on a well-structured investment process, just like the benchmark-oriented solution is. Inorder to not endanger the floor, the portfolio assets are invested primarily in highly liquidinvestment instruments under a very professional risk management regime.


A related approach is the absolute return concept. It likewise strives to earn a positive absolutereturn while providing capital protection, but has zero tolerance for potential losses. In otherwords, it sets the loss floor at the level of the initial portfolio value. The absolute return conceptthus satisfies the wishes of many investors in theory. However, it has not passed the acid test inpractice. The 2007/2008 global financial crisis revealed how unrealistic it is to be able toanticipate severe market corrections and to sell risk positions in time to avoid price losses. Theabsolute return concept has therefore become almost irrelevant in its original sense, which wasto achieve high returns in rising markets and to preclude losses in weak market environments.

Volatility-limiting conceptThis investment concept aims to participate as much as possible in rising market opportunities andto significantly cushion losses (but not to prevent them entirely) in the event of severe marketcorrections. This is done by putting a limit on portfolio volatility. When the markets are wracked bynervousness and correspondingly wide price fluctuations and portfolio volatility nears the predefinedlimit, riskier assets have to be cut back in favor of lower-risk investments. This lowers portfoliovolatility and reduces vulnerability to big losses in value. The objective of the volatility-orientedconcept is relative rather than absolute loss limitation.

In a nervous market environment, the volatility limit thus takes over the function of being the maincontrol parameter for managing the portfolio. Since volatility is usually lower in sideways drifting orrising markets, under normal market conditions the composition and thus the performance of theportfolio is determined primarily by the prevailing investment views. This is also where the bigadvantage lies compared to the capital protection concept: under favorable market conditions, theinvestor can participate fully in the uptrend within the predefined volatility limit while during correctionphases, a safety net is activated once a predetermined threshold has been reached.

3. Volatility-limiting investment concept in detail

Sights set on smoothing out portfolio volatilityThe primary objective of this investment approach is to smooth out portfolio volatility across the normaland stress phases of a market cycle. Daily portfolio volatility serves as the main parameter for theasset allocation. Short-term volatility is weighted more heavily to factor in the present market situation.Instead of a classical benchmark, the reference measure is a portfolio volatility limit predefined by theinvestor that may not be exceeded in any phase regardless of the market trend.

In sideways drifting or rising markets, portfolio volatility usually holds constant if the portfolio issufficiently diversified. During such periods, market and investment views can be expressed withgreater accentuation in the portfolio than they can under the benchmark-oriented approach becausein contrast to benchmark-oriented portfolios, the asset allocation is not steered via tracking error.Such accentuations could be reflected, for example, in a heavier weighting of favored regions in theequity allocation, though the equity allocation doesn’t necessarily have to differ substantially from theone in the benchmark-oriented asset allocation. When risky assets undergo a sharp correction, whichincidentally is often accompanied by mounting investor risk aversion, portfolio volatility approaches thedefined upper limit. In such an event, the portfolio must be systematically shifted out of risky assetsand into lower-risk ones because the primary objective is to consistently adhere to the volatility limit.


Figure 3: Reduction of risk during stress phases

During protracted stress phases, part of the negative performance can be averted using a volatility-oriented approach.However, participation in rising prices is delayed during recovery phases.

Source: Credit Suisse. For illustrative purposes only.

This systematic course of action restricts the portfolio’s loss potential. In this sense, risk managementmoves into the foreground in the investment process ahead of other decision-making parameters. Atthe same time, psychological factors are taken into some account since, in difficult markets, investorsdevelop an aversion to risk and tend to dodge sustained stress by reducing risk.

Different forms of volatility limitsThe volatility-limiting concept can be implemented in different ways. Basically, it is a matter ofdifferentiating between the following two approaches: target volatility; maximum volatility limit.

Target volatility means that the stipulated volatility target has to be adhered to by the portfoliomanager at all times. Since the markets are continually in flux and portfolio volatility thereforealways fluctuates a bit, pursuit of a predefined target volatility necessitates frequent transactions.If nervousness mounts on the markets, riskier securities must be divested immediately to complywith the portfolio’s volatility target. When the markets calm down again, risk exposure has to beratcheted back up step by step. However, the high transaction frequency causes correspondinglyhigh transaction costs.

In actual practice, it has been most common for a maximum volatility limit to be set. Individualasset categories can additionally be specifically included or ruled out, if need be with a maximumallocation limit that of course has to be compatible with the maximum volatility limit. In a normalmarket environment, the maximum volatility limit is not used up, meaning that the portfolio volatilitylies below the set limit. So if the markets are suddenly rattled by a hectic flurry of activity, thereremains some leeway for further observation and analysis of the markets and, if need be, for initialincremental selling of risk positions. This prevents “brush fires” on the securities markets fromimmediately triggering transactions that then have to be reversed once the markets settle down.However, if the downward pressure on the markets intensifies, risk exposure must be graduallyreduced. The maximum volatility limit can briefly be touched or even slightly exceeded during suchphases.

Alongside this basic form, there are other different ways to limit portfolio volatility. For example,the investor can set a volatility band within which the portfolio is allowed to move. With thisvariant, limits are set on both the maximum and minimum allowable volatility. In another variation,a classical benchmark-oriented concept can be combined with a volatility-controlled concept. This


Performance of risk-oriented portfolioPerformance of benchmark-oriented portfolio

approach attaches a maximum volatility limit to a benchmark strategy. The portfolio is managedin accordance with benchmark targets as long as the maximum portfolio volatility limit is notexceeded. But if the limit is breached, the fluctuation bands for the more aggressive categoriesof the benchmark strategy are overridden to systematically reduce risk.

Adjusting the volatility limitThe portfolio volatility limit can be set firmly or flexibly over a given period. Under the flexible option,it is adjusted depending on the portfolio performance over the course of a given period (it isadjusted quarterly or yearly, for example). It is therefore a multilevel volatility limit in this case. Thismeans that the portfolio’s performance during the course of the year is factored into the decision-making process, with constrained risk capacity taken into account if need be. Risk capacity wouldbe constrained, for example, if the maximum volatility limit were to be lowered due to a returnearned in a given period. Assuming, for example, that a maximum volatility of 7% applies for aperformance down to -3%, the risk budget drops from 7% to 5% if the loss exceeds -3%.

Reducing the volatility budget lowers the loss potential because the portfolio becomes moredefensive. When the markets calm down again and volatility diminishes accordingly, the riskbudget increases, enabling the investor to participate in an upturn from that moment onward.Such rules-based conduct avoids the problem of determining the right timing for reentering themarket or unwinding hedging strategies.

Handling the volatility limit in actual practiceWhen determining strategic asset allocation, the defensive cash and fixed-income asset categoriesshould be allowed to be assigned weightings up to 100% regardless of the set volatility limit. Thisenables the portfolio to be consistently positioned defensively in a very tough market environment.The maximum weighting of the riskier equities asset category, in contrast, depends on the volatilitylimit. Alongside cash, fixed-income securities and stocks, alternative assets can also be included witha maximum weighting of 15% or 20%, for example. The investments are made in very liquidinvestment instruments in order to maintain an ability to react quickly to altered market conditionswhen needed.

The two severe market corrections that occurred in summer/autumn 2008 and in 2011 frequentlyinform investors’ decisions when setting volatility limits. They want to be better protected during suchstress phases but are able to cope well with minor losses in value. They accordingly set the maximumvolatility limit at a rather high level. The sensitivity of the portfolio to market events must be carefullycalibrated with the client’s expectations. Moreover, it would be unrealistic to expect that losses canbe completely prevented during stress phases while at the same time being able to achieve highreturns in rising markets.

In actual practice, it has proven successful when the effective portfolio volatility pursued by theportfolio manager in calm market periods hovers around 25% below the maximum volatility limit. If amaximum limit of 8% has to be adhered to, for example, the portfolio volatility normally stands ataround 6%. This provides sufficient leeway to exploit investment opportunities within the scope of thedefined investment profile. Moreover, it leaves a large enough buffer to cope with minor marketcorrections with mildly elevated volatility without having to make hasty transactions. In contrast to thetarget volatility approach, with this technique the portfolio manager is not constantly operating right atthe limit and therefore is not forced to maneuver hectically when the need to take action arises.


Advantages of the volatility-based solutionIn contrast to the benchmark-oriented investment approach, which focuses on a return target anduses a target tracking error to determine the desired deviation from the benchmark, the volatility-limiting concept puts loss limitation in the foreground. During stress phases with elevatedpsychological pressure, the volatility-limiting concept enables investors to resort to rules that theyinstated in calmer times.

Compared to the capital protection concept, the volatility-based portfolio is much moreaggressively positioned during favorable market phases, which – just like the benchmark-orientedinvestment approach – enables investors to profit from market opportunities within the scope oftheir personal investment profiles.

Opportunities The investment strategy is very flexible and enables investments in the most attractive asset

categories and asset classes worldwide. The portfolio manager ensures that the portfolio volatility stays below the limit set by the

investor. The individual investments are made in very liquid and transparent investment instruments in

order to be able to react flexibly to changing market conditions.

Risks The volatility-oriented approach is an investment solution aimed at containing losses, but does not

provide a guarantee against losses. In the event of very turbulent markets, portfolio risk can briefly exceed the maximum volatility limit. Portfolio performance depends on the correctness of the financial-market views, the right choice

of investment instruments and the level of the volatility limit.

Summary: Volatility-based investment approach


Features1. Market and investment views

Market and investment views are implemented with the volatility limit taken intoaccount.

2. Comprehensive risk controlA volatility target or limit enables portfolio risk to be efficiently and comprehensivelycontrolled.

3. Active investment style It combines a risk-oriented approach (in weak markets) with a return-oriented approach

(in sideways drifting or rising markets), effectively smoothing out return performanceduring substantial correction phases.

A portfolio based on the volatility-limiting investment approach is more actively managedthan a classical benchmark-oriented portfolio that employs a target tracking error.

4. Liquid and transparent investment instrumentsThe portfolio is invested in very liquid and transparent investment instruments in orderto be able to take action quickly and flexibly.


4. Glossary

Correlation A measure of how prices of different asset categories or investment instruments move in

relation to each other. The correlation coefficient quantifies the strength of the relationship

as a figure ranging between –1 and +1. The closer the coefficient is to 1, the stronger the

correlation. If the coefficient is –1, the asset categories or investment instruments move

exactly in opposite directions. A coefficient of 0 indicates that there is no apparent correlation

between the asset price movements.

Floor The maximum limit below which the value of the invested capital is not allowed to fall.

Tracking error This measures the tactical asset allocation’s divergence from the strategic asset allocation

and serves as a control parameter in the benchmark-oriented investment concept.

Volatility A metric for measuring risk. Volatility measures a return’s fluctuation range around a

mean. It can be applied to an individual security (such as a stock, for instance), interest

rates, a market index or, for example, to the performance of a portfolio. The more

unsteady the return performance, the higher the volatility and thus the riskier the

investment. Volatility is therefore also regarded as a “fear barometer”.

Produced by Marketing Core Investments & MACS.

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