Risk control is the new investment paradigm
Slipping in under the post GFC radar, in May this year Standard & Poor’s launched a new set of indices, the S&P “Controlled Risk” ASX 200 index – complementing a range of similar indices launched over offshore markets. There has been an explosion of investment products in the last few weeks which rely on the analytics behind the S&P Controlled Risk indices – and how they work (and why) may just be the single most important advance in investment management this year.
The new approach relies on measuring volatility of the underlying market, and increasing/decreasing exposure to the market as volatility falls/rises. Standard & Poor’s comments that:
“The S&P 500 Risk Control 10% Index and the S&P/ASX 200 Risk Control 15% Index track the return of a strategy which dynamically adjusts the exposure to each underlying index in order to control the level of risk.
The S&P 500 Risk Control 10% Index targets a volatility level of 10% and the S&P/ASX 200 Risk Control 15% Index targets a volatility level of 15%. If the risk level reaches a threshold that is too high, the exposure to the Index is decreased in order to maintain the target volatility. If the risk level is too low, then the Index will employ leverage to maintain the targeted level of volatility.”
Details of the Standard & Poor’s risk control index methodology are at: www.strategyindices.standardandpoors.com.
There are 4 key points to note about this “volatility target” method:
- Volatility is a leading indicator of price movements – in the case of rapidly gapping market falls like 1987, or slowly trending down markets like pre GFC, volatility starts to rise rapidly before share prices fall;
- To minimize capital losses which would be experienced in falling markets, reducing exposure during periods of high volatility, and winding it back up as markets become more benign (and thus as they appreciate in value) is a demonstrably valid risk management technique (see below);
- Using rising volatility as a signal to reduce exposure to sharemarkets is thus a far more precise tool than the traditional alternative, of relying on price as a signal to guide buying and selling shares. This observation is at the heart of the problems with traditional benchmark aware managed funds – why should we sell stocks just because their share price is falling, or buy stocks just because their share price is rising? Surely a better way to manage risk is to reduce or increase exposure as risk rises or falls?
- There is a subtle but powerful by product of this approach, in so far as it relates to the cost of derivatives which are hedged using the volatility target method. Derivatives hedged using the volatility target method are cheaper than traditional alternatives like simple call options. Why? Delta hedging by derivatives providers requires them to buy shares to cover the risk of exercise of the derivative (ie a call option). The delta hedging model tells the providers how many shares they should hold, on any given day during the term of the option, to properly cover the risk of being exercised. As share prices rise, the delta of a call option rises too – but as the share price falls below the strike of the call option, the issuer’s delta falls as well. Just prior to the expiry of an option, if it is “in the money” (ie the share price is above the option exercise price) the issuer will hold 1 share as a hedge for every 1 call option sold. But the problem is that hedging models rely on normally working markets, since if a market gaps rapidly up or down, the hedge may not be able to be adequately adjusted. This makes it risky for derivatives issuers, and in current markets with residually high volatility, the cost of buying options is extremely high as issuer’s add in high margins to compensate for, amongst other things, high volatility and the high risk of hedging. Using volatility target methods significantly reduces the risk to the issuer of the derivative, thus reducing the cost it has to charge for the derivative.
The overall result of the volatility target method is that it’s makes buying options cheaper and more powerful. Buying call options over general market indices like the ASX 200 at current levels is expensive, translating to capped upside unless the buyer is prepared to pay exorbitant prices. That is, since call options cost so much at current levels, buyers typically end up having a position which does not allow unlimited upside. For example, call “spreads” giving exposure to upside capped at 130% of starting index levels are common in today’s market. For the same outlay an investor can buy a volatility target based option with no upside capping. At the same time, the internal risk management of a volatility target option means that it will reduce its exposure to the underlying market as the volatility in the market rises – and since rising volatility typically coincides with falling prices, this means that volatility targeting outperforms the underlying asset’s performance in falling markets.
In summary, the new “controlled risk” approach, which relies on increasing or decreasing exposure to assets as risk (volatility) falls or rises, is a powerful tool which allows for the creation of investments which are cheaper to buy and less risky than traditional investments, including simple call options as well as traditional benchmark aware managed funds. This is likely to be one of the key new technologies for the next decade.
© Alpha Structured Investments
