In an investment environment dubbed the “new normal”, the name of the game is to find asset classes that have little or no correlation with each other, and then combine them efficiently in a portfolio to achieve the best risk and return trade-off for investors.
In truth, that’s always been the aim of portfolio construction and asset allocation; it’s just that in recent times, more attention has been paid to finding new and exciting asset classes that can be deployed in that quest.
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The starting point in the quest to define new asset classes is to define what an “asset class” is. According to van Eyk Research’s head of ratings, Matt Olsen, one definition is that “if it has its own risk premium that can be monetised”, then it’s an asset class. And if it’s an asset class, it can be employed in a portfolio construction context to help to optimise an investor’s risk-reward trade-off.
For the past several years, investors in equities have experienced a rollercoaster ride. Volatility is, on the one hand, unnerving and is more usually deemed the enemy of the investor; but it can, on the other hand, be harnessed to help improve the performance of investment portfolios.
Volatility is increasingly being viewed as an asset class in its own right. It’s not necessarily an intuitive conclusion to reach, but it’s a prime example of how new thinking is being brought to the task of portfolio construction in a bid to get the very best returns for clients with the least pain and discomfort along the way.
“Anything with a price can have volatility,” Olsen says. Volatility can be viewed as an asset class, because it’s possible to construct an index to represent volatility, and then there are derivative instruments that can be created over that index and traded in their own right. But more on that in a moment.
Volatility is essentially the “variability of a return stream around the average of that return stream”, Olsen says. “It’s the deviation from the average which is really the volatility.” Implied sharemarket volatility is reflected in a volatility index, called the VIX. Volatility indexes exist for a range of different markets – the S&P 500 Index, for example, or the S&P/ASX 200 Index.
In essence, the implied volatility of a sharemarket – reflected by the relevant VIX – is calculated by using a weighted average of the settlement prices of put and call options written over the sharemarket index. An explanatory fact sheet issued by the Australian Securities Exchange (ASX) says that two maturities of options are used, “with the nearby [options] having at least a week until expiry”.
“The volatility of options closest to maturity is interpolated with that of the options farthest from maturity to arrive at a constant 30-day indication of expected volatility,” it says. This calculation produces an index value, but investors need to understand how to interpret that value. Simon Ho, founder and director of Triple 3 Partners, says the VIX is infact “simply a statistic”. It’s a useful statistic, to be sure, but you can’t invest in a statistic.
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