Over the past decade volatility investing has emerged as a new asset class. Dominicé’s Investment Team has carried out an analysis of the risk-return profile of long volatility and relative value volatility strategies and their added value to an equity portfolio.
The analysis is based on the returns of the CBOE Eurekahedge Long Volatility and Relative Value Volatility Indices for the period from January 2005 to March 2020 and has reached the following conclusions:
- Long volatility strategies provide superior returns in an equity market crash, but they cannot simply be considered an equity hedge. Our research shows that long volatility strategies utilize timing skills, i.e. they gain substantially with an explosion in volatility, but only give back a portion of their profits when volatility normalizes.
- Relative value volatility strategies, similar to long volatility strategies, have, up until 2012, also capitalized on rising realized volatility. From 2012 these strategies anticipated the start of collapsing volatility and adopted net short volatility exposure, without fully hedging the resulting market Beta. This allowed them to capitalize on both risk factors, short Vega and long Beta. Then, in March 2020, these strategies swiftly adapted their exposure and returned to long Vega, delivering a respectable crisis Alpha.
- There is greater dispersion in relative value volatility investment styles and hence in our opinion it is important to run the analysis at the level of individual strategies. Given that the source of returns of a relative value volatility fund is truly distinctive, or at least more extensive than the equity risk premium, makes it an extremely valuable addition to a traditional portfolio.
- Finally we ascertained that a hypothetical portfolio consisting of the S&P500, Eurekahedge CBOE Long Volatility and Relative Value Volatility Indices, yields a 7% annual return, with a Sharpe ratio more than double that of the S&P500 Index, resulting in a much more effective investment.
For the full analysis and commentary, click here to read our Research Paper.
