Long Volatility Strategies versus Tactical Asset Allocation

Both are great, both have challenges

August 2022. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Long volatility strategies are attractive diversifiers, but complex and not easily accessible
  • Tactical asset allocation for equities may be considered as an alternative
  • There is no clear winner between these two options

INTRODUCTION

Risk management in portfolio construction is primarily achieved via diversification or rules-based frameworks. The former simply means combining asset classes that tend to be lowly correlated, eg bonds and equities over the last few decades. The latter implies defining rules on when to exit, eg if the S&P 500 drops below the 200-day moving average, then reallocate capital from stocks to bonds.

Diversification has become more challenging as the primary diversifier, ie bonds, have become less attractive given low interest rates, especially in an environment of rising interest rates. Furthermore, many seemingly uncorrelated strategies like hedge funds or private equity have been found to provide nothing more than hidden equity exposure. 

Investors frequently consider tail risk hedge funds for diversification, but these tend to be too negatively correlated to stocks, which does not make them immensely useful tools in portfolio construction. Long volatility strategies are more suitable as they feature only moderately negative correlations, but there are only a few asset managers offering this strategy and none in a public vehicle like an ETF (read Building a Long Volatility Strategy without Using Options).

Given this, perhaps a rules-based approach is superior as that can be easily implemented. In this research note, we will contrast long volatility and tactical asset allocation (TAA) strategies for equities.

DIVERSIFICATION BENEFITS OF LONG VOLATILITY STRATEGIES

Long volatility strategies aim to benefit from rising or high stock market volatility, and use options as well as risk-off assets in portfolio construction. The pay-off during a stock market crash will be lower than from a tail risk hedge fund, but there will also be less consistent losses during bull markets.

We use the CBOE L