Written on 15 December 2011.
Insurance companies and pension funds have traditionally played an important role as providers of long-term risk capital and, in a world of deleveraging credit institutions, are crucially needed to finance economic development.
However, recent and forthcoming changes in accounting and prudential standards encourage long-term institutional investors to invest in low risk assets that are highly correlated with liabilities. Meanwhile, in the current low interest rate environment, institutional investors cannot meet their future obligations[i] out of the yields on these instruments. At the same time, risk-based capital charges and financial reporting standards penalise assets that offer high risk premia and make it expensive for long-term investors to directly hold volatile assets.[ii]
The study looks at the control of volatility as an objective[iii] and assesses various strategies to pursue this goal: a fixed mix of equity and risk-free assets, dynamic allocation between these assets targeting a fixed volatility, traditional portfolio insurance implementing a capital guarantee, and a target volatility strategy overlaid with a capital guarantee. The empirical focus on Asian equity markets is justified not only by the region's importance in the shifting balance of economic power but also by the higher volatility of these markets and the difficulty of hedging in the absence of local volatility derivatives.
Research results show that a target-volatility strategy allows for effective management of volatility and that it both significantly reduces the downside risks and improves the upside potential compared to a fixed-mix strategy. It also augments investors' access to the upside potential when a capital guarantee overlay is applied. Furthermore, the explicit management of volatility is found to reduce the cost of capital protection. The study also documents utility gains for risk-averse investors regardless of the presence of a capital guarantee overlay and argues that significant allocations should be made to structured equity investment strategies with volatility targeting.
The study has important practical implications for long-term investors. Though evidence is taken from examining Asian equity markets, the results are applicable in other regions and for asset classes that exhibit similar characteristics.
[More: Download the study]
[i] One medium-term option is to alter the nature of the obligations by passing more of the risk to policy holders and future pensioners, e.g. by moving away from guaranteed return products and defined benefit pension plans. This is ongoing and will have important social and economic consequences. Another possibility is to make a more astute use of financial techniques to transfer risk to the markets and thus reduce the cost of regulatory changes. This is the approach we are exploring.
[ii] Interestingly, sovereign bonds receive favourable capital treatment.
[iii] From a theoretical standpoint, a constant volatility portfolio is a key building block for asset allocation in a dynamic setting with stochastic volatility. Such a portfolio can also be used to efficiently deal with the problem of extreme risk arising from stochastic volatility. From a practical standpoint, there is increased demand for volatility targeting in the wake of recent market disorders as investors recognise that diversification is not a tool for downside risk control and that traditional portfolio insurance strategies do not explicitly aim at volatility control and, as such, may be sub-optimal tools for reducing regulatory capital consumption for market risk.