What are targeted volatility funds?

The exchange-traded fund (ETF) market in South Africa is currently experiencing a phase of rapid growth in terms of the number of new products being made available to investors. Last year 13 new ETFs were listed on the JSE, following nine new listings in 2017.

This has brought the total number of local ETFs to 76.

This growth seems set to continue into 2019. Absa is currently in the process of issuing three new funds, which will list next week. The NewFunds Volatility Managed ETFs will be the first South African products to make use of targeted volatility strategies that are already popular in many other markets, particularly in Europe.

The premise behind these strategies is to offer investors exposure to a particular asset class – in this case equities – but to limit the volatility they experience. They do this by moving more of the portfolio into cash whenever volatility increases.

“They invest in a risky asset and a risk-free asset, and you shift between the two to keep the volatility of the portfolio at a targeted level,” explains Alex Matturri, the CEO of S&P Dow Jones Indices. “They are useful for investors that normally wouldn’t want to invest in a riskier asset but could do so if they could manage its volatility.”

Need for risk management

Len Jordaan, head of distribution for ETFs at Absa, explains that the motivation for developing these new products has been the need to embed risk management into index-tracking products in the local market.

“One of the biggest criticisms of the passive industry is that little risk management takes place,” he points out. “And this is a significant problem in South Africa where we have a very concentrated market.”

Anyone currently investing in Top 40 index tracker, for example, will be putting more than 22% of their money into Naspers. How that single company’s shares behave is therefore going to have a meaningful influence on how their portfolio performs overall. This might seem like a good idea as long as the Naspers share price outperforms, but it’s a material risk when it falls.

It is managing this downside risk that Jordaan argues is so important, because returns are asymmetric. As the graph below illustrates, if you lose 10% of the value of your portfolio, you need to make 11% from the lowest point to get that back. If you lose 50%, however, then you need to earn a 100% return to get back to where you started.

Source: Absa

Reducing your losses therefore has two important functions. Firstly, when the market turns you are starting from a higher base. Secondly, and as a consequence, you don’t need to take as much risk with your portfolio to earn the same long-term return, as you don’t need to capture all of the upside.

Volatility as an indicator

This is essentially what targeted volatility strategies aim to achieve. Since history has shown that increased volatility is a pretty good indicator of future short-term returns, if you can de-risk a portfolio when volatility increases, you have a good chance of limiting your downside risk.

“There is a strong inverse correlation between volatility and returns,” Jordaan points out. “When volatility spikes in equity markets, there is 99% chance that you will incur a loss in your portfolio the next day. So we are using volatility as an indication of when it is dangerous to be in equities.”

The chart below shows how this inverse relationship played out in 2008 and 2009. When volatility shot up, the market crashed, and as it came down, returns picked up.

Source: Bloomberg

This isn’t, however, always the case. There are times when the market suddenly lurches downward without any volatility signal. As one can see in the above figure, this occurred in May 2010 and September 2011. The Absa Managed Volatility ETFs therefore also include a second layer of protection through implementing a maximum drawdown level.

The backtesting of the NewFunds strategies has shown how that would have offered three clear advantages over using a static allocation between equities and cash. Their returns were higher, volatility lower, and their maximum drawdowns were significantly reduced.

Any strategy like this is, however, based on how markets have behaved historically. There are no guarantees that this will always be the case.

“There is a risk that you see high volatility and markets go up,” Jordaan explains. “We catch the inverse with the drawdown protection, but you will miss out on the upside if markets increase with high volatility. That is, however, not typically how equity markets have behaved.”

Having insurance

The attraction to investors is therefore that they are able to get exposure to equities, but with some insurance on the downside.

“It wasn’t by design that we are listing them now, but there is a lot that could happen this year that could affect equity markets quite dramatically,” Jordaan says. “At the same time it’s difficult not to be in equity markets because of where valuations are. So people want to be in the market, but they want some insurance.”

In a sense, these funds offer some of the attraction of hedge funds, although the strategies are quite different.

“I don’t think that we’re trying to replace hedge funds in a portfolio,” says Jordaan. “Hedge funds tend to use quite different strategies when it comes to capping your downside.”

However, because these are ETFs they can be used by other unit trusts, which may make them useful for other fund managers to employ.

“They could perform the role of a hedge fund in a unit trust,” Jordaan acknowledges, “although they are not necessarily hedge fund replacements.”