One minute on volatility strategies: it is worth a second thought
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2023 was outstanding – what is next?
Volatility strategies closed 2023 with an outstanding performance and very low volatility, underlining their positive contribution to a portfolio's overall return.
Volatility is one of the most established and stable alternative risk premia that has been observed in the liquid space for more than 30 years. A clear and comprehensible mechanism, which is similar to a classic insurance policy, enables a very attractive risk premium to be collected in absolute and risk-adjusted terms.
Since the sharp drawdown in 2020, volatility strategies have shown an impressive performance (see chart). Even the end of the low interest rate phase last year has not affected this positive development, on the contrary. The key to this success lies in the high volatility risk premium ("VRP"), driven by increased demand for hedging. Interestingly, many providers of insurance disappeared from the market after the coronavirus pandemic, opening up additional opportunities for the remaining investors in volatility strategies.
Currently, the medium-term total return expectation for volatility strategies is higher than ever before. But why is that? For one thing, the VRP remains at a high level. Even if it declines from the record levels after the Covid crisis, it remains higher than before the pandemic for the structural reasons mentioned above. On the other hand, volatility strategies are implemented using derivatives, based on a portfolio of short-term bonds with good credit ratings. As interest rates have risen, the expected return from the underlying portfolio has also increased.
This results in an impressive absolute return expectation of 8.0 to 8.5% in total, which is made up of around 3.5% (money market) interest and 5.0% risk premium. These figures show once again why volatility strategies should have a permanent place in every portfolio.
A HIGH RISK PREMIUM LEADS TO HIGH RETURNS FROM THE VOLATILITY STRATEGY
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