Asset Allocation Implications of the Global Volatility Premium

The authors examined the role of volatility premiums in institutional investment portfolios. They began by defining and calculating standardized returns to volatility exposure for a variety of global asset markets. They found that shorting volatility offers not only a very high and statistically significant Sharpe ratio of approximately 1.0 but also substantial tail risk. Although classic diversification benefits are limited, the authors show that modest allocations to short volatility exposure could have enhanced long-term returns, in one case increasing the portfolio’s combined Sharpe ratio by 12%. This empirical study provides a comprehensive statistical and economic analysis of the global volatility risk premium, with a special emphasis on its practical role in institutional asset allocation. Our inferences about the premium are based on a composite return series, which we call the Grand Volatility Composite Portfolio (GVCP). We derived the GVCP from a dynamic trading strategy applied to a variety of instruments, including swaptions, variance swaps, and options on futures. The GVCP blends the returns of volatility-sensitive instruments in 34 unique markets across four asset classes: equities, bonds, currencies, and commodities. Our data begin in January 1995 and end in May 2013 and thus include the recent global financial crisis. A strategy-based approach is required to derive the GVCP not only because pure volatility returns are not universally available, but also because risks vary among instruments, across asset classes, and over time. Our derivation also accounts for transaction costs, which have a material impact on performance.To facilitate comparison, we combined the 34 volatility return series on an equal risk–weighted basis within each asset class to form four composite asset class series, and then among asset classes to form the GVCP. We chose an equal-weighting scheme because of its simplicity and transparency. We found that negative (short) volatility premiums are widespread, statistically significant, and economically meaningful. Consistent with earlier studies, we found that shorting volatility offers not only a very high Sharpe ratio of approximately 1.0 but also substantial tail risk, which we defined as the worst monthly return in our sample. Selling volatility is consistently profitable, including during the five-year period surrounding September 2008. We found that transaction costs played a significant role, reducing gross returns by 47% on average in our sample. The left-tail risk of volatility returns was substantial and far larger than that of primary assets. For volatility assets, the median worst monthly return, expressed as a fraction of annual standard deviation, was –1.6, whereas the corresponding median figure across primary assets (equities, fixed income, currencies, commodities, and even hedge funds) was just –1.2. The worst return of the GVCP was –2.3%, more than twice its annual standard deviation. We also found, however, that lengthening the period of evaluation for the GVCP reduced the severity and impact of tail events, primarily because of the GVCP’s high mean and how its risk is managed.We evaluated the GVCP’s economic significance both by confirming that its returns could not be explained by common linear factors, per the global Fama–French model, and by evaluating the performance of hypothetical strategic investment benchmarks when the returns of the GVCP were added in small measures. We found in a portfolio context that the worst returns of the GVCP tended to coincide with large losses in primary markets, thus limiting the GVCP’s role in institutional portfolios as a cornerstone strategic risk premium, like stocks and bonds. Nevertheless, our analysis suggests that investors without short positions in volatility may be forfeiting a profitable investment opportunity, as adding the GVCP in small amounts to typical portfolios would have enhanced long-term returns, increasing the combined Sharpe ratio by as much as 12% in our sample.Editor’s notes: The authors may have a commercial interest in the topics discussed in this article. This article was reviewed and accepted by Executive Editor Robert Litterman.Authors’ note: The views and opinions expressed herein are those of the authors and do not reflect the views of Goldman Sachs. The backtests and analysis described herein are provided for educational purposes in reliance on past market data with the benefit of hindsight and do not reflect actual results. If any assumptions used do not prove to be true, results may vary substantially. Our research does not take into account specific investment objectives, investor guidelines, or restrictions. Investors must also consider suitability, liquidity needs, and investment objectives when determining appropriate asset allocation. All swap and swaption data are courtesy of J.P. Morgan Research, copyright 2014.