Volatility caps recommended in order to limit equity risk

February, 2014 Print

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Local authority funds concerned about a possible equity market crash can apply volatility capping, according to Schroder Investment Management.

Local authority funds are often not permitted to use hedging methods based on illiquid, over-the-counter derivatives supplied by an investment bank, but the volatility capping method uses only highly-liquid exchange-traded futures, which most pension funds are able to use for efficient portfolio management. Schroders’ head of portfolio solutions, John McLaughlin, commented: “Volatility control techniques are widely used in the insurance industry – this is a tried and tested approach.” McLaughlin said that the technique utilises the fact that a market correction is often associated with high volatility, as happened in 2008. “Volatility is a mathematical measure of stress, so to take the simple example of a US equity portfolio, for which the normal level of volatility is about 12%, you can set a volatility cap at 15% let’s say, and then activate downside risk management whenever volatility exceeds this level.”

To implement the risk management, McLaughlin said that exchange-traded futures contracts on the main market index, the S&P 500, would be used. “If market volatility rose to 20% for example, we would sell sufficient futures contracts to reduce the volatility of the portfolio back down to 15% again.” He added that this method means that the hedging technique is independent of the equity manager used, so an investor can continue to use a successful active equity manager, while hedging against an equity market fall separately through an overlay via Schroders. He added that this basic technique can cover a wide range of risk assets through the use of a small number of the most liquid futures contracts, because most asset classes become highly correlated during a significant market downturn.

In terms of how much capital is required to implement the overlay, McLaughlin said that typically 7-15% of the assets to be protected may need to be converted to cash in order to margin the futures position. “There is no cash drag however, because we would immediately buy futures on top of the cash position to maintain equity exposure” he added.

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