Incorporating The Volatility Risk Premium Into Portfolios
By Wei Ge, Ph.D., CFA, Senior Researcher, Parametric This is the third paper in a series that Parametric has published on the VRP. The first paper discusses the sources of the volatility risk premium, explaining that the VRP may come from three distinct sources: behavioral biases, economic factors, and structural constraints faced by investors (Ge [2014]). The second paper compares the three most common ways to monetize the VRP, all of which utilize financial derivatives: option strategies, variance swaps, and VIX Index futures (Ge [2015]). It concludes that investors may seek to harvest the volatility risk premium with either a dedicated capital allocation or an overlay strategy and suggests that using equity index options may be the best approach for investors to monetize the VRP, closely followed by utilizing VIX Index futures. The focus of this paper is to discuss how investors can incorporate the VRP into a balanced portfolio (60% equity/40% fixed income portfolio) or an equal-weight multi-asset diversified portfolio. Both dedicated VRP allocations and overlay VRP constructs are used to harvest the VRP, as suggested by the prior study. The paper concludes that both methods can potentially enhance investors’ portfolio returns as the VRP is an attractive and traditionally untapped source of returns that has low correlations with traditional risk premiums. Both approaches are shown to provide return enhancement without having to materially alter the risk profile of an investor’s portfolio; though the overlay approach potentially does so in a more capital-efficient fashion. Therefore, when permissible, investors may want to consider utilizing an overlay strategy as a potential method to pursue improved portfolio returns. Otherwise, investors may still enhance their portfolios’ returns by incorporating the VRP via a dedicated vehicle. DATA AND METHODOLOGY This study analyzes the VRP in the context of two scenarios typical of investors’ portfolios. The first scenario is a balanced portfolio consisting of 60% equity allocation and 40% fixed income allocation (the 60/40 Portfolio). Investors usually invest in a mix of equity and fixed income to balance two major objectives of their portfolios, to match liability requirements and to grow assets. The 60/40 Portfolio is the perennial model portfolio for analyzing an investor’s asset allocation as it should offer investors the growth prospects of equities and the stability of fixed income assets (Ambachtsheer [1987], Bernstein [2002]). Some have further suggested using a more dynamic allocation approach (Inker and Tarlie [2014]; Xiong et al. [2013]) to enhance the basic 60/40 portfolio. The 60/40 portfolio is considered by most practitioners a solid model portfolio representing the basic structure of portfolios. In this study, the 60% equity allocation is represented by the S&P® 500 Index and the 40% fixed income allocation is represented by the Barclays Capital Aggregate Index. Twenty-five years of annual return data is used in this scenario (Jan 1990 to Dec 2014). The second scenario is an equal-weight multi-asset portfolio ( the Diversified Portfolio), consisting of five sleeves with equal 20% capital allocations in five different asset classes, including: Equity – S&P 500 Index Treasury – Barclays US Total Treasury Index Credit – Barclays Capital Credit Index Commodities – Bloomberg Commodity Index Real Estate – FTSE EPRA/NAREIT Real Estate Index This scenario is intended to model generic diversified portfolios of investors that are less focused on equity. The Diversified Portfolio includes five different asset classes: equity, treasury, credit, commodities, and real estate 1 . Twenty-three years of annual return data is used for this scenario (Jan 1992 to Dec 2014), with the shorter date range due to lack of data for some of the constituent asset classes (e.g. commodities). In this study, a static asset value-based allocation is used to make the scenarios simple. The conclusions and lessons drawn from this study can be readily applicable to more sophisticated portfolios with more asset classes, such as absolute return assets, hedge funds, private equity, foreign allocations, or portfolios constructed using algorithm-driven methods. As suggested by our prior study, option-based strategies can be used to add exposure to the VRP for the model portfolios. Both the overlay strategy and the dedicated allocation approach are tested in this study and they are constructed as follows: The Dedicated VRP Construct – 50% S&P 500 Index exposure, 50% Treasury Bills, and a short strangle consisting of shorting S&P 500 Index puts and calls layered on top of the base assets. Both short positions of put and call options are explicitly and fully collateralized by the underlying S&P 500 Index and Treasury Bills and have notional values equal to the S&P 500 Index or Treasury Bills allocations. When incorporated into a portfolio, assets must be reallocated from other assets to the Dedicated VRP Construct. The Overlay VRP Construct – a short strangle based on shorting S&P 500 Index options with equal notional values 2 . Unlike the Dedicated VRP Construct, the short puts and calls are implicitly collateralized by the equity and fixed income allocations in the base portfolio. The Overlay VRP Construct does not require capital allocation and can be added on top of existing portfolios. In this study, 10% or 20% of the Dedicated VRP Construct allocation is used for both the 60/40 and Diversified portfolios. The equivalent level of the Overlay VRP Construct, short strangles consisting of 5% and 10% of call and put selling (totaling 10% and 20%) are added to both scenarios to test the overlay strategy. The weights of the Overlay VRP Construct are designed to compare with the Dedicated VRP Construct allocations based on equal footing. The results with dedicated allocations or overlay strategies are compared with the original scenarios both visually and quantitatively. RESULTS Figure 1 examines the performance statistics of the variations of the 60/40 balanced portfolio. From Jan 1990 to Dec 2014, the S&P 500 Index delivered an average annual return of 9.62% with a standard deviation of 14.64%, translating into a 0.45 Sharpe Ratio. The Barclays Capital Aggregate Index delivered an average return of 6.49% with a standard deviation of 3.67%, translating into a 0.95 Sharpe Ratio. The 60/40 Portfolio delivered an average annual net of fee return of 8.29% with a standard deviation of 9.08%, translating into a 0.62 Sharpe Ratio. It has a maximum drawdown of 32.53%. The performance of the 60/40 Portfolio falls between the two constituent series. The variations with the Dedicated VRP Construct allocations are named the “55/35/10” and “50/30/20” portfolios, respectively, with 55% or 50% S&P 500 Index, 35% or 30% Barclays Capital Aggregate Index, and 10% or 20% allocations to the Dedicated VRP Construct. The 55/35/10 portfolio delivered an average annual net of fee return of 8.52% with a standard deviation of 9.06%, translating into a 0.64 Sharpe Ratio. The 50/30/20 portfolio delivered an average annual net of fee return of 8.74% with a standard deviation of 9.06%, translating into a 0.67 Sharpe Ratio. The Overlay VRP portfolios, with the same 60% S&P 500 allocation and 40% Barclays Capital Aggregate allocation as the base, and the Overlay VRP Constructs consisting of 5% or 10% call selling and put selling (totaling 10% and 20% and named “Overlay 10” and “Overlay 20,” respectively), have similar levels of risk and maximum drawdown, but the annual net of fee returns improved to 8.69% and 9.10%, translating into Sharpe Ratios of 0.66 and 0.70, respectively. Figure 1: Adding VRP to the Simulated Balanced Portfolio (Jan 1990 – Dec 2014) Click to enlarge Source: Parametric, 9/10/2015. STD is the annual standard deviation of the returns; SR is the Sharpe Ratio; Max DD is the maximum drawdown based on monthly returns; Beta is the regression beta against the S&P 500 Index. Net of fee returns have a 35 bps management fee and are net of expected transaction costs. Simulated performance is for illustrative purposes only, does not represent actual returns of any investor, and may not be relied upon for investment decisions. Actual client returns will vary. All investments are subject to loss. You cannot invest directly into indexes. Please refer to the Disclosures included at the end of this material for additional important information. The simulated performance statistics indicate that adding the VRP into a balanced portfolio indeed improves the back-tested annual net of fee returns, from 23 bps and 45 bps for the Dedicated VRP Construct allocations to 40 and 81 bps for the two Overlay VRP Construct examples. The risks of the VRP variation portfolios remain similar to the base 60/40 Portfolio, in both return standard deviations and maximum drawdowns. Figure 2 plots the growth of the wealth of the five portfolios (60/40 Portfolio, two Dedicated VRP variations, and two Overlay VRP variation portfolios). The results confirm the improved wealth-generation capabilities of the VRP-based portfolios, with the VRP overlay strategies delivering better return enhancements. Figure 2: Simulated Growth of Wealth – Balanced Portfolio Without or With the IRP (Jan 1990 – Dec 2014) Click to enlarge Source: Parametric,9/10/2015. Net of fee returns have a 35 bps management fee and are net of expected transaction costs. Simulated performance is for illustrative purposes only, does not represent actual returns of any investor, and may not be relied upon for investment decisions. Actual client returns will vary. All investments are subject to loss. May not invest directly into indexes. Please refer to the Disclosures included at the end of this material for additional important information. Figure 3 examines the simulated performance of the variations of the Diversified Portfolio. From Jan 1992 to Dec 2014, the Diversified Portfolio, consisting of 20% allocations to five asset classes, delivered an annualized net of fee return of 7.09% with a standard deviation of 8.16%, translating into a 0.58 Sharpe Ratio. It has a maximum drawdown of 34.80%. The first variation of the Diversified Portfolio with the Dedicated VRP Construct allocation (Diversified + 10% Dedicated VRP Construct) consists of an 18% allocation to each of the five base asset classes plus a 10% allocation to the Dedicated VRP Construct. It delivered an annual net of fee return of 7.39% with a standard deviation of 7.97%, translating into a 0.63 Sharpe Ratio. The second variation with the Dedicated VRP Construct allocation (Diversified + 20% Dedicated VRP Construct) consists of a 16% allocation to each of the five base asset classes plus a 20% allocation to the Dedicated VRP Construct. It delivered an average annual net of fee return of 7.70% with a standard deviation of 7.81%, translating into a 0.68 Sharpe Ratio. The two variations with Overlay VRP Constructs (Overlay 10 and 20 Portfolios) have similar levels of risk and maximum drawdowns, but the annual net of fee returns improved to 7.50% and 7.91%, translating into Sharpe Ratios of 0.62 and 0.67, respectively. Note again that the exposure to short call and put options is covered implicitly by the allocations to equity and treasury assets. Figure 3. Adding VRP to the Simulated Diversified Portfolio (Jan 1992 – Dec 2014) (click to enlarge) Click to enlarge Source: Parametric, Credit Suisse Hedge Fund IndexesSM, 9/10/2015. STD is the annual standard deviation of the returns; SR is the Sharpe Ratio; Max DD is the maximum drawdown based on monthly returns; Beta is the regression beta against the S&P 500 Index. Net of fee returns have a 35 bps management fee and are net of expected transaction costs. Simulated performance is for illustrative purposes only, does not represent actual products or returns of any investor, and may not be relied upon for investment decisions. Actual client returns will vary. All investments are subject to loss. May not invest directly into indexes. Please refer to the Disclosures included at the end of this material for additional important information. The simulated performance statistics indicate that, again, adding the VRP into a multi-asset diversified portfolio improves the expected overall performance. The improvement net of fees is 30 bps or 61 bps annually with the Dedicated VRP Construct allocations, and 41 bps or 82 bps net of fees with the two Overlay VRP Constructs. The risks of the VRP variation (Overlay and Dedicated) portfolios, again, remain similar to the baseline multi-asset diversified portfolio or even more subdued, in terms of both return standard deviations and maximum drawdowns. Figure 4 plots the wealth index of the five portfolios (the Diversified Portfolio, two Dedicated VRP variations, and two Overlay VRP variations). The performance improvement is most significant for the Overlay 20 portfolio, followed by the Diversified + 20% Dedicated VRP portfolio, Overlay 10 portfolio, and the Diversified + 10% Dedicated VRP portfolio. Figure 4: Growth of Wealth – Simulated Diversified Portfolio Without or With the VRP (Jan 1994 – Dec 2014) Click to enlarge Source: Parametric, 9/10/2015. Net of fee returns have a 35 bps management fee and are net of expected transaction costs. Simulated performance is for illustrative purposes only, does not represent actual products or returns of any investor, and may not be relied upon for investment decisions. Actual client returns will vary. All investments are subject to loss. Please refer to the Disclosures included at the end of this material for additional important information. Simulated statistics of the two scenarios indicate that all the VRP variation portfolios improved the performance of the base portfolios and all have similar levels of risk as the base portfolios, in terms of returns volatility and maximum drawdowns. The return improvements are higher for the Overlay VRP variations than with the Dedicated VRP allocations. Implicit leverage may be a part of the reason behind the superior returns of the overlay approaches. When an overlay VRP construct with zero weight is added on top of a portfolio, an implicit leverage is introduced; it may add extra returns, but may also suffer losses. The addition of the short index option strangle layer on the base portfolio, however, introduces minimal changes to the risk profile of the portfolio, probably due to two reasons. First, the Overlay VRP Construct is implicitly fully collateralized by the equity or treasury allocations in the underlying balanced or diversified portfolios, reducing risks of exacerbated drawdowns. Second, the Overlay VRP Construct with the short index option strangle has an equity beta close to zero and a negative returns correlation with the equity market (Ge [2015]). The portfolio’s overall risk characteristics does not change significantly with the addition of the Overlay VRP Construct, exemplified by the similar standard deviations and maximum drawdown attributes of the variations. Therefore, the overlay approach of incorporating VRP into an investor’s portfolio should be considered the preferred approach if there are no constraints on leverage in investors’ mandates. The addition of the Dedicated VRP Construct allocations does not change the risk characteristics of the base portfolios for similar reasons. The overall performance enhancement, however, is slightly less significant due to the need to accommodate the Dedicated VRP Construct by reducing other assets in the portfolio. This method of incorporating the VRP may be utilized when the client is more risk averse or the overlay approach cannot be used due to legal constraints or mandate requirements. CONCLUSION This the third paper in the series that examines the equity insurance risk premium. This piece focuses on how to incorporate the IRP into investors’ portfolios. It builds on the conclusions of the two previous studies and explores the best method of incorporating the IRP into generic portfolios. Based on the conclusion of the previous study on the best way to monetize the IRP, this study analyzes the use of index option strategies, i.e. shorting S&P 500 Index option strangles, as either a collateralized Dedicated IRP Construct, or as an Overlay IRP Construct. The application of the IRP enhancement is analyzed based on two generic scenarios, one is the typical 60/40 balanced portfolio representative of many investors’ portfolios, and the other is an equal-weight multi-asset diversified portfolio consisting of five asset classes, representing typical portfolios of investors that are less focused on equity. The IRP can be beneficial to investors’ portfolios and the IRP addition in both formats can provide both return enhancement and diversification. The Dedicated IRP allocations improves both scenarios on a net of fees by a roughly annualized 2 to 61 bps while reducing the overall risk levels slightly. The Overlay 10 portfolio improves both scenarios on a net of fees by approximately 40 bps on an annualized basis, utilizing the same short strangle construct as the Dedicated IRP Construct. The Overlay 20 portfolio improves the net of fee return by approximately 80 bps. Neither overlay variation alters the risk profile of the portfolio significantly. The final conclusion is that investors may utilize the overlay approach to incorporate the IRP into their portfolios if legally permissible, by taking advantage of the implicit leverage embedded in the overlay approach, which should deliver elevated returns without significantly changing their risk profile. On the other hand, if the investors are risk averse or are constrained by legal restrictions or mandate requirements from utilizing the overlay approach, the incorporation of the IRP as a dedicated allocation may also be a good choice as it is capable of delivering potentially better returns without introducing significant extra risks. REFERENCES Ambachtsheer K. P. “Pension Fund Asset Allocation: In Defense of a 60/40 Equity/Debt Asset Mix.” Financial Analysts Journal, 43 (1987), pp 14-24. Bernstein P. L. “The 60/40 Solution.” Bloomberg Personal Finance, 2002. 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