Asset Allocation Using Volatility: Is Risk an Asset Class by Itself?

From the people who brought you Mortality and Longevity, comes an all new asset class, Volatility.  While it sounds like a fragrance commercial or movie trailer straight from nerd hell, Adam Warner writes that Goldman Sachs has announced that it will begin to include volatility as an asset class when making client asset allocation decisions.  While I may be tongue and cheek when writing about Goldman, and not agree with some of their decisions, they are really quite genius and most certainly have the balls it takes to run a Private Client group that is interested in providing their clients with something new.  Adam writes,  

After so much sturm und drang in the global markets in 2007, investors increasingly will view volatility as an asset that can be traded, just like stocks and bonds.

This view has long been touted by options pros, but now it's being bolstered by a Goldman Sachs research paper recently distributed to clients. In it, options strategists Maria Grant and Krag Gregory argue that stock volatility is an asset class, and that investors should commit money to it when they make asset-allocation decisions.

Volatility, in its most pure sense is the variability of asset returns.  It is used widely as measure of risk.  An index based on a volatility measure, the VIX is the most common tradeable representation of this risk.  It represents investors expectations of risk based on the S&P 500 stock index prices - and is commonly called the "fear gauge."  For more in depth analysis, visit Bill Luby's Vix and More blog for an orgy of great Vix-related material.  There are currently futures and options on the index and it is readily followed by most traders and even non-derivative folk.  The VIX derives its valued from the implied volatility of option prices.  This is gained by using the Black-Scholes Formula (or some similar option pricing model), inputting current option prices, interest rates, time to expiration, and stock price, and solving for the implied volatility.  Usually, but not always, the VIX is negatively correlated with stock prices.

When trading, volatility is something that should always be kept in mind and many believe position sizes should be reduced in volatile times and increased in times that are not as crazy.  People invest in volatility based products such as the VIX for various reasons.  Most do so to hedge their exposure to market volatility. For example, if you are a relative value hedge fund manager trying to capture some spread between two stocks by going long-short, and are using obscene leverage in order to do so, you may not want to expose yourself to the volatility of the overall market, since you are not making a directional bet between two companies and not the market as a whole.  Or, maybe you have a position that you do not wish to reduce, but not leave exposed to wild price movements that it may experience in a volatile market you foresee.  Buying some VIX futures helps you hedge this risk.

Some people, however, simply trade volatility by itself, buying and selling this measure of risk as they would a stock, option, or bond.  This is done through variance or volatility swaps.  My knowledge on this area is limited, so I will leave it at that and welcome any further comments. 

I am more interested in the idea of volatility as an asset class.  Traders should not be as concerned with the definition of an asset, since they usually are renting the security which they trading, and care little about its fundamental value just the cost of carry.  Investors should care more as they have a longer term time horizon and seek some sort of cash flows or appreciation to invest in an asset.  Assets, on the other hand, can be intangible such as knowledge, as we have seen on the balance sheets of many corporations.  They are also used in context with traits and characteristics - as in, "His negotiation skills are his greatest asset."  These assets can generate returns for those who hold it, and can be purchased by companies who wish to hire someone who has them.  I am very open to what and what isn't an asset, as long as it is able to be valued and people derive benefits from it. However, I just don't see volatility as an asset class (and would fit better as a hedge fund strategy under "Alternative Investments".  There are two main reasons why I believe this, they are its role in the process and its

1.  Volatility is a Asset Allocation consideration, not a choice.  Volatility measures price movement.  It measures not where a price is going, but the path it takes to get there.  The crazier the path, the more the investor should expect to make when he reaches his destination.  It is also a major determinant in allocating a portfolio.  Assets within a portfolio should be evaluated based on the amount of return one expects based on the amount of risk.  Both are measured somehow and evaluated.  Some ways to measure risk are historical and implied volatility and correlation with other asset classes.  Every investment is an indirect investment in volatility and to be long an asset you are long the volatility of the asset.  Since return is a payoff for risk, effectively hedging one's exposure to this risk should cost an amount comparable to the return - since the counterparty must be rewarded for taking on the identical risk.

2. The long run expected return on volatility should equal the risk free rate. 

Volatility is the result of an absence of liquidity for an asset at the given price.  The more liquidity that is available the more likely demand (and supply) to come after price movements, the less liquidity, the more chance for larger swings.  Since liquidity in general will never completely disappear or go to infinity, volatility will be what it is, noise around a trend. The best example of this is in the concept of gamma.  Gamma is the rate of change of delta - the change in option price that corresponds to a change in the stock price.  Someone who is short puts or calls is short volatility and has a position with negative gamma and susceptible to large price movements.  The chart below shows the relationship of gamma with volatility:

When volatility is low, gamma is relatively unstable, and time value is small for OTM options but increases dramatically as the stock moves more towards being ATM.  In general, the risk of being short volatility is the highest and volatility is cheap.  When volatility is high, the time value of calls are already bid up substantially, and large price movements won't really affect the value of the call option as much.  What this does is set up a trading range for volatility.  When volatility is low, it is best to be long volatility  at the money, but as volatility increases, the bell curve above above flattens to the high volatility curve and going short gamma becomes more attractive, as time value becomes too rich.

The volatility of volatility, therefore decreases as demand for the volatility increases and vice versa. Having volatility as an asset class, I believe, will cause a much flatter gamma curve, as it will create a demand for volatility once the market absorbs this excess liquidity and demand. Also those who are short gamma need to hedge their delta exposure along the way - adding liquidity to the investment that they wish to hedge , meaning it will serve as less of a hedge against the underlying volatility it was supposed to protect against, until the gamma and vega exposure you have is offset enough by the negative theta to leave you simply with the risk free rate.  If liquidity is dying out and trending up, so will short term interest rates.  Thus, allocating towards cash, is the pretty much the same thing and much a much safer way of reducing your exposure to volatility and volatility should be correlated with short term rate movements as it has been, shown by the chart below:

Now, I am not a derivatives expert by any means and this could be easily refuted and I welcome it because I really enjoy volatility and believe it is important.   However, I do believe this is just taking advantage of an opportunity to offer an interesting product to their clients and create liquidity for their internal funds or clients who mostly likely trade volatility very often and need an active market, and/or structured products.  Either way, I think its cool, and would be interested to see how it would be used and how it would perform.  I also think the idea of allocating away from greed to fear is just an interesting conversation to have with a client and actually good for their overall investment education - possibly making it worthwhile anyways.

    

Update - 12/18/2007 - 1:31 PM

Upon reading further, I see that the "volatility as an asset class" is to be short volatility.  This will create a position with negative gamma.  I thought it was more along the lines of a fund that traded volatility like a CTA trades commodities.  It doesn't change my viewpoint, however, since it creates a more liquid market for fear, thus minimizing the effect of a change in volatility.  If one insurer wrote insurance on houses in towns as hurricanes were hitting and made underwriting profits each time, more people would move in to do so.  If many people were already doing it, they then create a liquid market for something that is up to know an illiquid transaction.  It would follow that one insurer would most likely profit from high rates and ability to selectively underwrite risk due to fear and illiquidity.  Many insurers would create liquidity and slowly erode those profits until the liquidity of the market erased any underwriting profits and most likely exposed them all to the possibility of large losses.  Also, as hurricanes come down, people will be less fearful because they know there is liquidity in the insurance market, which gives them pricing power earlier in the event.  The market would be no different.  A more liquid market for fear at times great volatility, will cause subsequent times to be less volatile on average, as the market will begin to expect a bid to come in.   Instead it has the effect of adding to the fat tail exposure of those short volatility, and perverting their risk exposure.  This leaves out the effect of hedging your delta, which would stems from the fear that the volatility seller himself has, and incentive for the underlying to be less fearful. 

Overall a hedge reduces volatility and a hedge against volatility will reduce the volatility of volatility itself.  So being short volatility is to be long the volatility of volatility, and this could go one and on and on.  As more people go short volatility , they will pay too much for the hedge and earn a poor risk adjusted return.  So by adding liquidity to this as an asset class, you are doing nothing more but hedging yourself and as the asset class catches on in popularity and becomes more liquid, its returns become less attractive.  You should expect to earn something inline with the risk free rate over time and open yourself up to significant losses along the way.

Comments

[Zach]

Interesting to think of volatility as an asset class in and of itself. One could essentially be diversified even within this asset class trading volatility on commodities, interest rates, forex, equities, real estate, country or sector specific indices, the list goes on.

So would a good volatility manager have to be aware of volatility trends and histories in all other asset classes?

this is fun to mentally unpack.

[ZeroBeta]

Zach,

Thanks for the post. It is very interesting, but it is not really a deep market. While a hedge fund or other institutional investor could enter into a swap agreement on various types of volatility, the most liquid market is the VIX which is based on the S&P 500. My guess is Goldman will offer (probably already does) structured products based on some type of volatility measure on some major index, most likely the VIX.

I would think they would use volatility as an overlay, whereas they allocate a percentage of the portfolio to beta - the market, and allocate other portions to some uncorrelated strategies - such as Volatility, long/short pair trades, commodities, currencies, etc. You must be aware that when you are short volatility, you are sitting on very fat tail risk - small probability large losses ("picking up nickels in front of a steamroller") and positions can get risker as time goes on.

A good volatility manager, I guess would be aware of trends and histories, but I would think that he would have to be most aware of the risk he is sitting at at all times. These positions can change quickly, so he needs to make sure he has his risks well defined and hedged.

The only problem that I have is that volatility is the path an asset class takes to get to some desination. The markets are not like the straight path you take in say a treasury bill. It is a treacherous path that twists and turns. Trying to hedge your market risk is akin to taking the shortcut. It may work well 99 times out of a hundred, but one time you will end up trespassing in some guys backyard and find yourself staring down the barrel of a shotgun.

Best,

ZB

[registered investment advisor]

In my opinion, it is just another dangerous invention by Wall Street to pick your pocket.