By Adam Rudd
One way to characterise the continuous evolution of financial markets is to borrow an observation from Greek philosopher Heraclitus, ‘change is the only constant’. However, it is not always necessary to focus on the direction of change, but rather to consider the rate of change over time. This is the pretext of investing based on the volatility of an individual security or market, rather than its underlying properties.
So what is volatility? Well, the easiest definition is related to the likelihood that the returns of a security or a market will deviate from, or revert to, their historical average. Investors are able to position themselves to benefit from an acceleration in the rate of change, i.e. greater volatility, or a slowdown in change, i.e. less volatility.
In practice, how can investors benefit from such changes in market behaviour and what are the risks involved? To gain exposure to the potential volatility of a market security, investors can use a range of derivatives including variance swaps, calls, puts and swaptions, to name just a few. While this may appear a rather exotic toolset, in reality there are similarities to more traditional securities that underpin performance.
For example, in the same way that the price of a security is determined by the degree of confidence investors have regarding the future returns it will produce, uncertainty also plays a central role in determining the pricing of these securities. Typically, in an environment when investors are feeling nervous about the future – say because of geopolitical worries or economic shocks – they can increase their exposure to volatility securities. When they are feeling confident about the future and are looking to increase their risk exposure they may choose to sell volatility.
Let us consider how this works in practice. The current volatility of the Hang Seng China Enterprises Index (HSCEI) is low on a historical basis, implying that investor uncertainty is also low. However, the underlying composition of this index suggests that it may be vulnerable to a correction in the event of a marked slowdown in Asia. In particular, the HSCEI is concentrated, with four individual stocks accounting for more than 50% of the index and the total number of stocks equalling just over 40. In addition, the HSCEI has a large sector bias towards financials, which make up more than half of the index. This concentration of securities means that the correlation between the volatility of a given average constituent and the overall index is relatively high. Clearly, this presents an opportunity for an investor who believes that the market is not correctly pricing the outlook for Asian financials.
Of course, taking such positions can themselves be risky. One way to offset this is to take a relative value volatility position in another market, where the concentration risk is much lower. One example would be the S&P 500 stock market. While this index is likely to see volatility increase in the event of an Asian slowdown, the composition of the market is relatively diverse, with 500 stocks across a wide range of sectors. This means that even if a constituent’s volatility is relatively high, the overall index volatility is more likely to remain low. In this way, the investor can balance the implied volatilities between these two markets.
For an investor looking for greater diversification, the ability to employ these advanced investment strategies, in addition to more traditional approaches, is a useful way to help generate returns and offset risk. Of course, the dynamic nature of financial markets ensures that opportunities to exploit such strategies are constantly evolving. Capturing the available returns from volatility positions, at the optimum risk level, requires forensic analysis and a robust process – another similarity shared with more traditional investment approaches.
Adam Rudd, investment director, multi-asset investing, Standard Life Investments
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