We have been running an investment strategy based on volatility control – called IsoVol - since 2009. We were among the pioneers of this approach to portfolio management. It relies on the well-known phenomena of persistence in volatility regimes (clustering) and the negative correlation between risk and return. We dynamically adjust our market exposures accordingly: When volatility increases, we reduce exposure and vice versa. This keeps portfolio risk in line with our objectives, reduces drawdown risk and improves long-term risk-adjusted returns.
CANI - A continuous search for improvement
IsoVol is, in essence, a quantamental approach, associating the quantitative models developed by our financial engineers with the expertise of experienced portfolio managers. Over the past 11 years, we have experienced investment environments of all kinds – ranging from extreme complacency (2017), through full-blown crises (2009, 2011; 2020) to technological, political and geopolitical change.
We consistently seek to avoid linear thinking and confirmation biases. IsoVol is not a static process. On the contrary, thanks to our continuous search for improvement (‘Continuing And Never Ending Improvement’, or CANI), it is dynamic. In this respect, there have been many new developments in recent years, starting with the ETF market. We have been investing opportunistically using ETFs since 2015. They have enabled us to allocate a portion of our assets to precious metals.
2020 - Comparable to 1987 for stocks
We are now making a further improvement to our IsoVol process. 2020 was an exceptional year in stock markets, giving rise to a shock for risk assets comparable to that of October 1987 and an unprecedented rebound in valuations (see Exhibit 1 below). Nevertheless, 2020 also confirmed a phenomenon that began around five years ago. Financial market corrections are becoming more frequent and sharper. For example, the S&P 500 index saw as many shocks in the five years between 2015 and 2020, as over the 50 previous years from 1965 (see Exhibit 2 below).
In particular, this phenomenon could be due to the accommodative monetary policies adopted by central banks over too long a period. Today, 11 years after the subprime crisis, central banks are still engaged in widespread quantitative easing involving asset purchases and policy rates at the lower bound.
Central banks purchase assets according to a predetermined schedule and without consideration of valuations. These operations have a psychological effect because they inspire investor confidence. This perception of stability along with a pronounced search for yield leads to a rise in debt burdens, apparent, for example, in the widespread use of share buybacks by US companies.
As early as 1986, US economist Hyman Minsky in his book ‘Stabilizing an unstable economy,’ explained the idea that a perception of stability or comfort encourages investors to take excessive risks that could lead to a moment of illiquidity. The more frequent and sudden corrections in financial markets may in part result from this misleading perception among investors.
Covering the risk of a Minsky moment
By placing risk at the heart of our investment process, IsoVol management has controlled the realised volatility of assets we manage and supported our commitment to sustainable investing. However, in light of the risks highlighted by Minsky, we adjusted the rebalancing thresholds in 2015.
Similarly, as early as 2014, we dedicated a budget to buying options in our funds. These purchases add a beneficial asymmetry to our portfolio allocation. We reinforced them at the end of 2019 with the help of an overlay ‘O Cube’, responsible for monitoring our hedging transactions by incorporating multiple parameters, for example, volatility or asset class exposure levels.
An additional parameter in 2021
Nevertheless, in 2021, to take into account the probability of more frequent shocks leading to abrupt regime changes for volatility, we will add a further parameter in our IsoVol process: Acceleration. More specifically, we will now take into account how quickly changes in volatility occur.
If volatility is comparable to the speed of market dynamics, acceleration is the speed with which changes occur. In an acceleration phase of volatility, we will reduce the target exposure and conversely in a deceleration phase, we will increase our target exposure.
This improvement, implemented with a global portfolio approach, will be accompanied by an efficient management of the rebalancing operations in portfolios based on transaction costs and leverage based on stress tests. In this way, we will track the various volatility regimes more closely and, if necessary, adjust our exposures faster while reducing drawdown risk.
Adding a foil
We have often used the image of a sailing boat to explain our approach. We are adjusting our sails depending on the conditions. In 2021, we will add 'foils' to our kit. This innovation, derived from fluid mechanics, is a wing positioned and profiled to generate, through its displacement in the water, a carrying force that improves stability and increases the speed of a vessel. An acceleration in volatility will now serve as our foil.
Investing in IsoVol strategies means investing in quantamental portfolio management that seeks constant improvement to remain sustainably positioned among the best portfolio management teams worldwide of flexible, diversified asset portfolios.
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Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. The views expressed in this podcast do not in any way constitute investment advice.
The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.
Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).
Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.