The Implied Volatility of Your Investment Policy

In our introductory article on volatility, A Real-Life Stress Test, we argued that the capital markets have entered a prolonged cycle of higher expected volatility. We suggested this was a time of opportunities. Indeed, a well-designed investment policy and skilled managers would surely turn this volatility into a value-add for institutional investors.

In this article, we will discuss the notion of an investment policy’s implied volatility, and whether institutional investors should factor in volatility when designing their strategic asset allocation and monitoring procedures. We will address applications (of varying degrees) for investment policy design where alpha generation or de-risking is the primary goal.

As it stands today, the vast majority of institutional investors have a strategic asset allocation built on capital market return expectations and assumptions with regards to volatility and correlation. Such expectations and assumptions involve extensive use of past data and averages are assumed to remain consistent over the specified time frame. However, the question remains: Is volatility consistent? The answer is no, it fluctuates greatly.

While investors are still compensated for investing in risk assets – and it can be argued that excess returns have shrunk from a historical perspective – the implied risk of a balanced portfolio is far from being consistent. The volatility of risk assets is a volatile measure, yet we generally fail to recognize and address this notion when we design our investment policy.

Changes in volatility are important to monitor from an investment policy perspective. Higher volatility increases the risk of large drawdowns in the portfolio, while lower volatility decreases the ability for the portfolio to generate excess returns (alpha). This volatility bears an impact on capital market assumptions and portfolio behaviour.

Fiduciaries should consider the volatility in volatility when setting investment policies and writing rebalancing rules. A practical application for investors is that an investment policy with the ability to adapt to various volatile cycles will provide better outcomes.

Fiduciaries are also encouraged to consider the impact of the changing nature of implied volatility on two fundamental aspects of portfolio management:

- The long-term capital market return path of one or more asset classes may turn out to be much different than previously anticipated, making the policy allocation inadequate; and

- The presence of high volatility should influence how the portfolio is constructed and rebalanced.

In the face of market swings in valuations and volatility, the common practices of institutional investors have called for rebalancing asset classes back to pre-established portfolio weights, which is usually the strategic long-term policy allocation. When the market experiences high volatility and a drop in values of risk assets, an investor will therefore rebalance the risk assets’ allocation back up to the range of holdings specified by the investment policy, which is essentially contrarian behaviour and often leads to excessive rebalancing and higher transaction costs.

With regards to investment policy decisions, investors must acknowledge that financial markets periodically transition between cycles of normal volatility and high volatility, where risk assets display unusually high risks that may no longer fit with initial risk/return assumptions. Depending on the persistence and variability of volatile cycles, investors may wish to adapt their portfolio’s implied volatility to account for the current environment.

In other words, to maintain the risk of a theoretical consistent 60/40 portfolio, investors should consider de-risking during a higher cycle of volatility – i.e. moving away from risk assets. Rebalancing should take place but in a manner where holdings would be rebalanced to an acceptable level or risk-return tradeoff, hence reducing the extent of contrarian behaviour. Alternatively, in periods of low volatility, investors should consider increasing their exposure to risk assets to maintain the portfolio’s ability to generate the required return.

Deviations from the strategic asset allocation (known as tactical asset allocation) and the rebalancing methodology requires skill in order to be successful; it can be an active decision or a rule-based decision. In any case, understanding the dynamics of volatile cycles is very important in setting strategic asset allocation, rebalancing policy and tactical asset allocation parameters.

In our next article on Benefits Canada, we will discuss a number of portfolio construction strategies that can help institutional investors capture the value in volatility.