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High Volatility Reduces Risk

High Volatility Reduces Risk

By Moritz Seibert, edited by Niels Kaastrup-Larsen

My last article (Smooth Risk, May 2015) concluded that investors do not necessarily lower their risk by lowering the volatility of their returns. That’s because volatility and risk are two very separate matters.

"If investors are too risk averse and too keen on obtaining a smooth “all weather” return profile, odds are that at some point they will end up with the opposite."

Most investors feel losses stronger than gains of equal magnitude, which is why high volatility strategies are very much out of favor. Smooth return streams, in contrast, are very much in favor – a fact that’s especially true for institutional investors (the higher the volatility, the higher the career risk of the portfolio manager).

However, with respect to trend following CTAs, the best and most efficient use of capital is to have high leverage as long as the manager uses proper risk management techniques. Indeed, high leverage means comparatively higher volatility and much deeper drawdowns; but it also means a reduction of the overall investment risk, an increase in liquidity, and lower overall fees.

Instead of making a fully-funded allocation of 10 million to a CTA program with 20% volatility, consider allocating 5 million to the same program with 40% volatility.

  • Reduction of the overall investment risk – If the underlying trading system fails (e.g., due to extreme events such as the EUR/CHF spike earlier this year, manager fraud, bad system design, etc.), you will have lost 5 million instead of 10 million. Although still a loss, it’s clearly a better outcome.
  • Increase in liquidity – Since you have halved your capital commitment, the remaining 5 million are available for other opportunities. Liquidity is valuable because it includes optionality.
  • Lower overall fees – Depending on how you invest (notionally funded vs. an outright increase in the program’s volatility target, fund vs. managed account), your overall fees are likely to reduce. The lower the fees, the higher your net returns.

"Based on the above, I’d rather invest less with greater volatility than more with lower volatility."

Finally, there’s one more point: High volatility CTA strategies offer investors much better chances of actually achieving their personal return targets during an investment lifetime.
Imagine you are the manager of your own pension plan. The size of your future pension is a function of (a) your initial investment and any subsequent capital allocations, (b) your realized rate of return net of inflation and costs, and (c) time.

First, investment capital is limited to everyone. Second, we clearly cannot stop the passage of time. So, there’s not much we can do about (a) and (c). The factor we can attempt to change, however, is the net rate of return. And this is where high volatility trend following CTA strategies can work wonders.

"Investors shouldn’t be scared of volatility. Volatility also offers opportunities and, used wisely, it can reduce risk and improve your personal investment outcome."