Volatility strategies – are they all the same?

The volatility premium arises from the imbalance between supply and demand for hedging instruments, as for the S&P 500. Due to the risk aversion of most investors, there are more market participants seeking protection than offering it. This imbalance allows protection sellers to earn a very attractive premium. The volatility premium is observable across many asset classes and is well documented academically. One way to capture it is by selling hedging instuments.

Over the years, various investment strategies have emerged, each trying to capture this premium in the most effective way. For investors, it is not always easy to recognise the differences between those and, more importantly, to identify the critical factors when selecting them. Based on our team's decade-long experience in volatility strategies, we would like to highlight what we consider the key criteria for a successful approach. Essentially, they can be broken down into the following four aspects:

1. Hedging or not?

Most of the time, the volatility premium is positive. However, during rare market stress or crisis phases, the sold insurance becomes due, and losses must be covered. How is the strategy prepared for such situations? Losses tend to occur very quickly, making active loss-limiting measures either too late or very costly. Therefore, a volatility strategy should always include downside protection in the portfolio that can effectively limit losses or, ideally, even overcompensate for them.

2. Avoid over-optimisation

Volatility strategies are almost exclusively implemented using derivatives. These instruments are highly versatile and often lead to strategies becoming overly complex in an attempt to improve them. In reality, this usually results in a lack of transparency regarding the actual source of returns and the risks involved. It also increases the fragility of the strategy, as assumptions – such as correlations – may not materialise as expected. Discretionary strategies have a further disadvantage, as markets can move faster than people can make decisions or take action, with emotions like fear and overconfidence leading to misjudgments. A more suitable approach is a systematic one, with a clear philosophy that strikes a good balance between adaptability and robustness.

3. The human factor

A strategy is only as good as the people who execute it. Therefore, the experience of the team is crucial for the long-term success of the concept and covers several areas. The most critical aspect is experience during crises, such as the Covid-19 pandemic. Extreme market movements, fluctuating liquidity, trading disruptions, and other challenges are a real stress test for the concept, systems, trading processes, and especially the people involved.

Successfully navigating this for investors requires years of experience and a deep understanding of the markets, as well as thorough knowledge of the portfolio models, IT systems, risk monitoring, and trading capabilities being used.

4. Set-up

A factor that is even more critical when selecting volatility funds compared to other asset classes is the set-up. This includes not only providing the necessary resources to the team, such as computing power, data, and IT systems, but also the company’s overall focus on volatility strategies. These are typically derivative and quantitative, requiring a different mind-set than many traditional approaches. Ideally, they are at the core of the company's operations and receive all the necessary budgets and resources.

Conclusion: Since the Covid-19 crisis, various concepts in the volatility premium space have entered the market. As there has not been a significant crisis since then, the weaknesses of these are often not yet visible. The points outlined can serve as a helpful guide to identify potential issues before investing in a strategy.

Empureon volatility strategies at a glance:
Empureon Volatility One Fund (ISIN DE000A3D9GL3 (AK I))
Empureon Volatility One Fund (ISIN DE000A3D9GN9 (AK R))
Empureon Volatility ESG One Fund (ISIN DE000A3D9GU4 (AK I))
Empureon Volatility ESG One Fund (ISIN DE000A3D9GW0 (AK R))