Capital protection on top of target volatility: a smart combination

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Can you have your cake and eat it? In certain markets, investment protection strategies can cost substantial sums. Combining a capital protection strategy and a target volatility strategy smartly can help reducing costs, while maintaining the protection against sharp losses.

  • Limiting the downside of your capital by setting a target level below which protection kicks in
  • Using a volatility target to de-risk the portfolio in volatile markets and re-risk it in times of low volatility
  • Combining the two strategies allows for a lower exposure to risky assets in volatile conditions, limiting the need for capital protection

With central banks around the globe engaging in monetary easing, interest rates at record lows and equity markets becoming more volatile after years of positive performance, investors face multiple challenges to earn attractive returns. Understandably, investors desire robust portfolios that can withstand negative market developments, while delivering sufficient returns over time. In this context, protection strategies offset investment losses, but the opportunity costs may be an obstacle.

A capital protection strategy on top of a target volatility strategy can help reduce the costs. The Target Volatility strategy manages the risks of the underlying individual assets. The allocation to an asset rises and falls in line with volatility. This ensures a more predictable and smoother development of risk, making it easier for the Capital Protection strategy to manage a loss at the overall portfolio level.

What does a capital protection strategy do?

A Capital Protection strategy is designed to protect a certain percentage of the initial net asset value of the portfolio (the floor) over an agreed period.

  • Protection increases when the value of the portfolio falls and approaches the agreed lowest NAV or when the risk of the portfolio increases.
  • Conversely, protection is lowered as the value of the portfolio increases or when the volatility in the returns of asset classes falls.

Unlike option-based strategies such as buying a put, the choice of the underlying assets is not restricted by options markets and you do not have to allocate money upfront to finance the protection. In other words, in good times, protection will not cost anything.

Why add a target volatility strategy?

However, when markets are volatile and move sideways, you may be repeatedly selling and buying exposure. This comes at a cost. Since the strategy lags the markets, in a sideways moving market, you end up buying back exposure at a higher price than at which it was sold. This ‘gamma loss’ can be mitigated with less volatile underlying investments, such as a Target Volatility strategy.

These strategies de-risk the portfolio in times of heightened volatility and re-risk it in times of low volatility. There is empirical evidence that applying a Target Volatility strategy to equities to ensure constant volatility over time adds value.[1] Not only do Target Volatility strategies deliver higher Sharpe ratios than buying and holding the underlying risky asset, but they also reduce drawdowns as targeting a constant level of volatility helps to reduce tail risk.

Here’s how it works

As a benchmark, let’s take a euro-based multi-asset portfolio where we aim to protect 90% of the value on an annual basis without leverage. The portfolio is 60% equities and 40% diversified fixed income. Between January 2005 and March 2019, it returned an annualised 6.8% with a volatility of 9.5%.[2] The maximum drawdown was -36.2% and lasted from a peak in October 2007 to a recovery in September 2010 (see Table 1).

Table 1: Results of Target Volatility & Capital Protection strategies (back-tested; gross of fees in euros; Jan 2005-March 2019)2

Table 1: Results of Target Volatility & Capital Protection strategies (back-tested; gross of fees in euros; Jan 2005-March 2019)2

For illustration purposes only. Source: BNPP AM, Bloomberg, DataStream; 29/03/2019

Applying a Capital Protection strategy significantly reduced the volatility and halved the maximum drawdown with the recovery period shortened by close to a year. The return came out at a higher 7.2%, thanks to a significant drop of the negative return in 2008 where the benchmark lost 26%, while the strategy limited the losses to 9%.2

However, the ‘gamma loss’ can be substantial (see 2011 and 2016 underperformance in Table 2).

Protecting capital and containing volatility: becoming more relevant

The last column of Table 1 shows that using a Target Volatility strategy and a Capital Protection Strategy boosted the Sharpe ratio and reduced the maximum drawdown.

  • Allowing for an overweight in equities when volatility was benign helped lift the performance in years of rising and calm markets where the Capital Protection mechanism did not kick in.
  • It also helped limit the underperformance of the Capital Protection strategy in volatile V-shaped markets by pre-emptively reducing the exposure and limiting the need for protection (cf. Table 2).
  • The combination cost an average 60bp per year, which is 30% less than the Capital Protection strategy.

As concerns grow of late-cycle market volatility, more investors are now thinking about implementing protective strategies. A smart combination of a Capital Protection strategy and a Target Volatility strategy can help manage portfolio losses with reduced opportunity costs compared to traditional protection strategies.

Table 2: Annual performance of Target Volatility & Capital Protection strategies (back-tested; gross of fees in euros; Jan 2005-March 2019)2

Table 2: Annual performance of Target Volatility & Capital Protection strategies (back-tested; gross of fees in euros; Jan 2005-March 2019)2

For illustration purposes only. Source: BNPP AM, Bloomberg, DataStream; 29/03/2019

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.


[1] Predicting the success of volatility targeting strategies: Application to equities and other asset classes; Perchet et al; The Jounal of Alternative Investments; winter 2016

[2] 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.


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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.

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Mehdi-Vincent Hacini

Quantitative Analyst

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