(June 6, 2012) — Investors should look into diversifying equity portfolios with volatility derivatives, research by the EDHEC-Risk Institute concludes.
Interest has grown in the possible use of equity volatility derivatives as diversifiers for traditional and alternative portfolios, according to a paper titled “The Benefits of Volatility Derivatives in Equity Portfolio Management” published by the institute.
The research shows how volatility derivatives can be used to engineer equity portfolios with downside-risk protection. “This research proposes a novel approach to the design of attractive equity solutions with managed volatility, based on mixing a well-diversified equity portfolio with volatility derivatives, as opposed to minimizing equity volatility through minimum variance approaches, and shows that trading in volatility index futures or options can provide access to the equity risk premium while allowing for explicit management of the volatility risk budget,” Noël Amenc, Director of EDHEC-Risk Institute, said in a release.
The research’s key findings include the following:
1) A long volatility position shows a strongly negative correlation with the underlying equity portfolio. Meanwhile, adding a long volatility exposure to an equity portfolio results in improvement of the risk-adjusted performance of the portfolio.
2) The benefits of the long volatility exposure are found to be the strongest in market downturns, when they are needed the most.
3) The benefits of adding volatility exposure to equity portfolios are also found to be robust with respect to the introduction of trading costs associated with rolling over volatility derivatives contracts.
EDHEC’s paper follows recent research by Towers Watson that found that derivatives may become too costly and too complex for some pension funds to want to use. High fees and complex counterparty structures may drive institutional investors away from using derivatives, the research suggested. In the paper entitled “Is This the End of OTC Derivatives for Pension Schemes?” Towers Watson laid out how changes in regulation and market attitude to these investment tools will make it more costly and complicated for investors to use these investing vehicles.