Russell advises caution on volatility investing

Volatility investing is a currently underused strategy that has the potential to add value to a portfolio if implemented correctly, according to Russell Investments.

An investment in volatility allows investors to potentially benefit from the difference between the future volatility of an asset class and the implied volatility of options based on that asset, according to a research paper released by Russell.

Volatility could be used either as an investment in its own right or as a hedging instrument, and there are a number of strategies and products which enable investors to gain such an exposure, Russell states.

It is a relatively new and technical area and education has been a barrier to entry thus far, but there could be a ‘first mover’ advantage, according to Russell Investments senior analyst Chris Inman.

Instruments such as VIX futures and variance swaps provide a ‘pure’ exposure to volatility. The two main strategies are to go long, providing downside protection in the event of heightened volatility (which tends to coincide with negative equity returns); and shorting, which effectively involves selling insurance to investors who are willing to pay to protect themselves against the risk of volatility.

Inman warns that a short volatility investor needs to be aware that if the market is more volatile than anticipated, they will lose money.

Volatility is most suited to institutions as it is important to have the funding to be able to sustain potential losses, Russell stated. Current trading of volatility is most commonly linked to US indices such as the S&P 500, and it is not yet widely used in the Australian market.