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Ahead of the Curve: The risk premium of downturns

• Alternative risk premia strategies offer diversification and risk reduction
• Volatility risk premia strategies thrive as the diversification of assets increases

Alternative risk premia strategies can be helpful for institutional investor portfolios through diversification and risk reduction. They can also be used to complement an incumbent hedge fund or liquid alternatives allocation, or replace existing equity or bond risk while retaining potential upside.

Certain traits identify an alternative risk premium: the bearer of that risk is compensated; the strategy is persistent and pervasive in live trading as well as academic studies to be; and is demonstrable across diverse asset classes. 

The volatility risk premium (VRP) – defined as the difference between the implied volatility on options and the realised volatility on the underlying asset – is a pure and identifiable alternative risk premium.

Some investors believe the VRP ‘correlates at the wrong time’, a concern centred on losses when equity markets fall. Thus, it is instructive to split the analysis into two distinct datasets: outcomes when implied volatility is already elevated, such as post the tech bubble correction; and ‘type two’ datasets such as flash crashes and the 2008 global financial crisis (GFC), when implied volatility is out of alignment.

Short-termism is a criticism levied at financial markets, and we believe that the minimum frequency for performance measurement of alternative risk premium strategies should be quarterly. We examined the quarterly excess returns of the S&P 500 since 1996 and the negative quarterly losses to the performance of an S&P 500 VRP strategy across the period. Our analysis is then extended to the multi-asset arena. In presenting this information, we hope to illustrate VRP.

The S&P 500 is used as an underlying for VRP strategies. Given its use, the potential for strategy crowding to show up, and the availability of a long-term dataset of option prices, it is ideal for analysis.

Since 1996, it has recorded 27 negative quarters. By comparison, an S&P 500 VRP strategy – defined in this analysis as delta-hedged straddles implemented on a monthly basis – recorded positive returns in 16 of those 27 quarters, averaging a 1.4% quarterly return.

A key feature of figure 1 is the robust performance during positive equity excess returns, but uncorrelated returns on the downside. The former is perfectly rational, with investors happy to sacrifice returns to enjoy the convexity of owning optionality. 

The story is more nuanced during weak performance and defined by the speed of the correction for a level of implied volatility. Investors wish to purchase options as cheaply as possible but may be unconcerned whether a 5% correction occurs on a single day or over consecutive days. For a VRP strategy, the magnitude and ordering of returns can be fundamental. 

uncorrelated downside performance

The bursting of the technology bubble of the 2000s was dramatic as the global financial crisis: a peak-to-trough loss in the S&P 500 total return space of 47.4% compared with the 55.2% loss from 2007-09.

However, during the tech crash, a VRP strategy on the S&P 500 seldom dipped, weathering the collapse before continuing to accrue profits. As implied volatility remained persistently higher than realised volatility, sellers of implied volatility were able to capture that premium. Conversely, put protection buyers would have enjoyed short periods of positive returns, but it is likely to have been an expensive luxury as markets failed to fall far enough to justify the premium.

Such mechanics are not confined to extended S&P 500 bear phases. For example, the performance of a Euro Stoxx VRP strategy during the Greek crisis of 2010-12 was negative in only three months of that period. The mechanics held true, with implied volatility remaining higher than realised volatility, rewarding risk bearers.

‘Type two’ volatility events are often the primary source of concern for investors. Since 1996, the defining volatility event has been the GFC. It is reasonable, therefore, to expect an S&P 500 VRP strategy to have suffered, given the shift from a low to a high-volatility regime. However, the GFC only accounts for one of the aforementioned 11 negative quarters. 

Heading into the 2008 Lehman default, the S&P 500 VRP strategy continued to accrue gains as the equity index declined. With realised volatility pushing towards 80%, the VRP loses value but the underlying dynamics assert themselves; implied volatility resets higher and ‘forced’ buyers of optionality keep it elevated. The result is the VRP strategy’s return to profitability by November 2008 despite equities not bottoming until March 2009.

What happens when one extends this to a multi-asset context? We re-run our quarterly analysis with a VRP strategy diversified across five assets from four asset classes. 

As figure two illustrates, a diversified strategy performs better than our single-asset S&P 500 VRP strategy – registering positive returns in 21 of the 27 negative S&P 500 quarters, at an average return of 1.6%. On those six outlier quarters, we observe compelling asymmetry and drawdown recovery, with a swifter return to parity, and increased profitability in the two subsequent quarters.

By looking at all quarterly losses in the S&P 500 since 1996 and comparing the performance of both an S&P 500 VRP strategy and a more diversified VRP strategy, we demonstrated that the volatility risk premium does not ‘correlate at the wrong time’. It is, in fact, additive to portfolios over these quarters. The strategy underpins the results, profiting from participants’ desire to purchase options at a premium to protect or speculate. In periods of equity stress, these mechanics are amplified, enabling option sellers to sell at increasingly profitable premiums. It holds true across asset classes.

Philip Strother is head of systematic research at Fulcrum Asset Management

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