RACHEL-ANN M. TENIBRO PRODUCT RESEARCH PRESENTATION
Cs turbulence
1. Risk-oriented investment strategies – investment concept
with volatility limit
Volatility as an effective control parameter in turbulent
markets
1. New conditions on the financial markets call for
new investment concepts
Unpleasant correction phases
A “normal” market environment is characterized by a generally tolerable return fluctuation range
(i.e. return volatility) accompanied by relatively low correlations between individual market
segments. Under such market conditions, balanced portfolio diversification is an efficient
investment approach. Amid steady return prospects, a sensible combination of individual asset
categories and asset classes reduces overall portfolio risk.
But if elevated uncertainty and sustained selling pressure prevail on the markets, portfolio risk
can jump sharply without the allocation of riskier assets such as stocks or foreign-currency-
denominated bonds having been raised. This is illustrated, for example, by the return fluctuations
and thus volatilities recorded during the periods from mid-2008 to mid-2009, from May to June
2010 and from August to September 2011, which hit readings far above the historical average
in some cases.
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Contents
1. New conditions on the financial
markets call for new investment
concepts
2. Overview of investment
concepts
3. Volatility-limiting investment
concept in detail
4. Glossary
René Küffer
Global Head iMACS
Risk-oriented investment concepts offer distinct advantages during market
corrections
Experiences from the past five years have shown that a classical investment approach
linked to a benchmark is not ideal in every market environment. For instance, during
periods of elevated uncertainty and sustained selling pressure on the securities markets,
portfolio risk, and thus loss potential, can increase sharply without the allocation of risky
assets having been raised. This effect can cause sleepless nights, especially for cautious
investors with high sensitivity to risk or losses.
In order to avoid such stress phases, an active asset management strategy focused on
limiting losses can present a very effective alternative. Two solution approaches present
themselves here: the by now established capital protection concept and the comparatively
lesser known investment concept that employs a volatility limit. Whereas the first approach
sets a floor that the portfolio’s maximum loss in value cannot exceed, the second
approach sets a ceiling for the portfolio’s maximum volatility.
Thomas Isenschmid
Head Client Portfolio Managers
iMACS
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Figure 1 tracks the evolution of the weekly volatility of the S&P 500 stock index. Although the
volatility normally ranges between 10% and 30%, it broke out of that range during the
aforementioned stress periods. In late 2008 it even spiked to a reading of 80% – i.e. a level three
to four times higher than the average fluctuation range – within the span of just a few weeks. During
those stress periods, the S&P 500 stock index was susceptible to much stronger fluctuations than
it is in a normal market environment. The probability of suffering a substantial loss in value on a
broadly diversified portfolio thus increased considerably without the allocation of risky assets having
been changed.
Figure 1: Evolution of S&P 500 stock index volatility
Last data point: 28 December 2012
Source: Credit Suisse. For illustrative purposes only.
Remedy in sight?
Although the financial and debt crisis appears to be under control, it has by no means been resolved
yet and is likely to continue to subject the markets to repeated stress tests in the years ahead. So
this raises the question of whether there are investment approaches that can control and reduce
portfolio losses, particularly during stress periods. Because one thing seems certain: severe market
corrections cause nervousness among many private and even professional investors. The longer-term
investment horizon that is advocated during calm and objectively rational periods on the securities
markets quickly gives way to an impulsive near-term mindset whose paramount goal is to avoid all
further losses.
Professional (active) asset management involves various investment concepts. For example, it is
possible to draw a distinction between the following approaches:
the classical benchmark-oriented concept;
risk-oriented concepts.
The benchmark-oriented concept reduces overall portfolio risk through balanced diversification. The
expected market trend is taken into account by overweighting or underweighting individual asset
categories and asset classes in accordance with the Investment Committee’s market and investment
views. The goal is to outperform the market by employing tactical decisions. Ultimately, though, the
portfolio largely remains subjected to market fluctuations.
Risk-oriented concepts enable the portfolio to profit from rising markets, but at the same time provide
a certain degree of protection against substantial losses in value. So compared to the benchmark-
oriented concept, risk-oriented concepts offer a highly attractive additional dimension for investors who
have above-average sensitivity to risk or losses.
0
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Dec 12Dec 11Dec 10Dec 09Dec 08Dec 07Dec 06Dec 05Dec 04Dec 03Dec 02
Volatility index (VIX)
Average fluctuation range
%
3. Figure 2: Benchmark- and risk-oriented investment concepts
Source: Credit Suisse. For illustrative purposes only.
2. Overview of investment concepts
Benchmark-oriented concept (also known as the classical or relative-value concept)
This investment solution orients itself toward the longer-term performance of the financial
markets. Its goal is to replicate a market portfolio that is broadly diversified across a variety of
asset categories and to earn an excess return through active portfolio management. The basis of
this approach is the long-term investment strategy (the strategic asset allocation or benchmark
weighting) devised in accordance with the investor’s risk profile and return expectations. But
depending on the Investment Committee’s market expectations and investment views, individual
asset categories will be overweighted or underweighted (tactical asset allocation) while adhering
to set deviation bandwidths. For example, when stock markets are falling, the equity allocation
can be scaled back but cannot be completely reduced. Under active portfolio management,
tracking error, which measures the deviation between the tactical allocation and the strategic
allocation, is used as the main control parameter.
Portfolio risk is predetermined via the strategic asset allocation. However, as explained earlier,
portfolio risk can rise substantially during market phases fraught with elevated uncertainty and
sustained selling pressure. Moreover, in such an environment, the correlation between the
different asset categories and asset classes often increases because mounting psychological
pressure causes investors to tend to sell off risky assets relatively indiscriminately. This reduces
the effect of diversifying risk, which additionally ratchets up portfolio risk and thus loss potential.
Consequently, the portfolio can suddenly exhibit an undesired aggressive risk profile without the
long-term investment strategy ever having changed. However, market corrections sooner or later
are followed by a movement in the opposite direction. Such rebounds reduce portfolio risk, and
the investor can profit from some substantial price gains particularly on riskier assets (provided
that he or she withstood the psychological pressure and did not divest them).
This investment solution is feasible for investors who are willing to accept a certain degree of
fluctuation in the value of their assets. The magnitude of the fluctuations varies in accordance
with the investor’s specific risk profile and the corresponding mix of asset categories. The higher
the allocation of more aggressive asset categories, the longer the investment horizon should be
in principle.
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Benchmark-oriented Risk-oriented
Diagram of
performance
over market
cycle
Investment focus Aimed at a predefined investment strategy Aimed at avoiding or reducing losses.
Active portfolio management based on
the Investment Committee’s market
expectations and investment views.
The loss limit is monitored and adhered to
by reducing investment risk if the portfolio
approaches the loss or volatility limit.
Investment goal Outperformance of a designated benchmark. Limitation of loss potential in the event of
substantial market corrections.
Maximization of investment return in a
normal market environment.
Investment style Active porfolio management based on the
Investment Committee’s market expectations
and investment views.
Return
Market
Relative return
Time
Return
Market
Time
Smoothed
return
4. Risk-oriented concepts
As mentioned earlier, risk-oriented concepts were developed for investors who have elevated
sensitivity to risk or losses. They are designed to enable investors to profit from rising markets,
but are also designed to provide a certain degree of protection against substantial losses in value
in the event of protracted market corrections. For this purpose, the investor sets a loss or
fluctuation limit that the overall portfolio is not allowed to exceed.
The limit can be set in two ways:
Determination of a value loss floor for the overall portfolio (absolute loss limitation).
Determination of a ceiling for portfolio volatility (relative loss limitation).
Like the benchmark-oriented concept, risk-oriented investment concepts start off with active
portfolio management. Using the Investment Committee’s market expectations and investment
views as a basis, the aim is to seize market opportunities in order to maximize the return on
investment. This means that with due regard paid to the investment strategy geared to the investor’s
risk profile, riskier assets can definitely be included in the portfolio and can even be assigned a
substantial weighting. Additionally, though, the loss limit set by the investor – regardless of whether
an absolute or relative loss limitation – has to be taken into consideration at the portfolio level. It
takes on central importance when the financial markets correct sharply (if an absolute loss limitation
has to be adhered to) or when volatility on the markets climbs to an above-average level (if a portfolio
volatility cap has to be complied with). If the portfolio value or portfolio volatility approaches this
barrier, the portfolio manager is compelled to reduce risk in order to adhere to the limit. If the
markets relax and the portfolio value or portfolio volatility returns to a comfortable distance from the
set limit, risk positions can gradually be built back up again in order to capture market opportunities.
Since the markets first have to calm down before exposure to riskier assets can be ratcheted up
again, the investor “misses out” on the first stage of the recovery following the trend reversal. But
on the other hand, the investor’s losses were effectively contained during the preceding correction
phase.
Risk-oriented concepts are not devoid of risk because the investor remains invested in the financial
markets, but they do reduce losses. And they offer an additional attractive aspect from a longer-
term investment perspective. If an investor suffers less losses during severe market corrections, in
a favorable environment less risk has to be taken to compensate for those losses. Risk-oriented
solutions thus limit losses in bad times and alleviate performance pressure in good times.
If the loss limit is defined as a value loss floor for the portfolio, this is actually an investment concept
with capital protection. If the desire is to keep portfolio volatility under control, this has to do with a
volatility-limiting concept. Both approaches are outlined below.
Capital protection (or floor) concept
The aim of this concept is to generate a positive absolute return and at the same time to ensure
capital protection, with the investor accepting limited loss risk. To protect capital, the investor sets
a bottom boundary or floor that defines the maximum allowed loss in the portfolio’s value
(absolute loss limitation). The floor is geared to the investor’s risk profile and can be adjusted as
needed. It is usually raised as the portfolio’s value increases.
The portfolio manager safeguards adherence to the floor while taking into account a wide array
of risks such as credit, issuer and liquidity risk, for example (as well as equity risk if this asset
category is even taken into consideration at all given its comparatively high volatility). If the value
of the portfolio approaches the floor, risk must be gradually scaled back. Since the leeway for a
loss in value is normally relatively small (i.e. the floor is set just a few percentage points below
the initial portfolio value), the floor is treated as the main parameter guiding the management of
the portfolio in any market environment. Apart from that, the management of the portfolio is
based on a well-structured investment process, just like the benchmark-oriented solution is. In
order to not endanger the floor, the portfolio assets are invested primarily in highly liquid
investment instruments under a very professional risk management regime.
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5. A related approach is the absolute return concept. It likewise strives to earn a positive absolute
return while providing capital protection, but has zero tolerance for potential losses. In other
words, it sets the loss floor at the level of the initial portfolio value. The absolute return concept
thus satisfies the wishes of many investors in theory. However, it has not passed the acid test in
practice. The 2007/2008 global financial crisis revealed how unrealistic it is to be able to
anticipate severe market corrections and to sell risk positions in time to avoid price losses. The
absolute return concept has therefore become almost irrelevant in its original sense, which was
to achieve high returns in rising markets and to preclude losses in weak market environments.
Volatility-limiting concept
This investment concept aims to participate as much as possible in rising market opportunities and
to significantly cushion losses (but not to prevent them entirely) in the event of severe market
corrections. This is done by putting a limit on portfolio volatility. When the markets are wracked by
nervousness and correspondingly wide price fluctuations and portfolio volatility nears the predefined
limit, riskier assets have to be cut back in favor of lower-risk investments. This lowers portfolio
volatility and reduces vulnerability to big losses in value. The objective of the volatility-oriented
concept is relative rather than absolute loss limitation.
In a nervous market environment, the volatility limit thus takes over the function of being the main
control parameter for managing the portfolio. Since volatility is usually lower in sideways drifting or
rising markets, under normal market conditions the composition and thus the performance of the
portfolio is determined primarily by the prevailing investment views. This is also where the big
advantage lies compared to the capital protection concept: under favorable market conditions, the
investor can participate fully in the uptrend within the predefined volatility limit while during correction
phases, a safety net is activated once a predetermined threshold has been reached.
3. Volatility-limiting investment concept in detail
Sights set on smoothing out portfolio volatility
The primary objective of this investment approach is to smooth out portfolio volatility across the normal
and stress phases of a market cycle. Daily portfolio volatility serves as the main parameter for the
asset allocation. Short-term volatility is weighted more heavily to factor in the present market situation.
Instead of a classical benchmark, the reference measure is a portfolio volatility limit predefined by the
investor that may not be exceeded in any phase regardless of the market trend.
In sideways drifting or rising markets, portfolio volatility usually holds constant if the portfolio is
sufficiently diversified. During such periods, market and investment views can be expressed with
greater accentuation in the portfolio than they can under the benchmark-oriented approach because
in contrast to benchmark-oriented portfolios, the asset allocation is not steered via tracking error.
Such accentuations could be reflected, for example, in a heavier weighting of favored regions in the
equity allocation, though the equity allocation doesn’t necessarily have to differ substantially from the
one in the benchmark-oriented asset allocation. When risky assets undergo a sharp correction, which
incidentally is often accompanied by mounting investor risk aversion, portfolio volatility approaches the
defined upper limit. In such an event, the portfolio must be systematically shifted out of risky assets
and into lower-risk ones because the primary objective is to consistently adhere to the volatility limit.
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6. Figure 3: Reduction of risk during stress phases
During protracted stress phases, part of the negative performance can be averted using a volatility-oriented approach.
However, participation in rising prices is delayed during recovery phases.
Source: Credit Suisse. For illustrative purposes only.
This systematic course of action restricts the portfolio’s loss potential. In this sense, risk management
moves into the foreground in the investment process ahead of other decision-making parameters. At
the same time, psychological factors are taken into some account since, in difficult markets, investors
develop an aversion to risk and tend to dodge sustained stress by reducing risk.
Different forms of volatility limits
The volatility-limiting concept can be implemented in different ways. Basically, it is a matter of
differentiating between the following two approaches:
target volatility;
maximum volatility limit.
Target volatility means that the stipulated volatility target has to be adhered to by the portfolio
manager at all times. Since the markets are continually in flux and portfolio volatility therefore
always fluctuates a bit, pursuit of a predefined target volatility necessitates frequent transactions.
If nervousness mounts on the markets, riskier securities must be divested immediately to comply
with the portfolio’s volatility target. When the markets calm down again, risk exposure has to be
ratcheted back up step by step. However, the high transaction frequency causes correspondingly
high transaction costs.
In actual practice, it has been most common for a maximum volatility limit to be set. Individual
asset categories can additionally be specifically included or ruled out, if need be with a maximum
allocation limit that of course has to be compatible with the maximum volatility limit. In a normal
market environment, the maximum volatility limit is not used up, meaning that the portfolio volatility
lies below the set limit. So if the markets are suddenly rattled by a hectic flurry of activity, there
remains some leeway for further observation and analysis of the markets and, if need be, for initial
incremental selling of risk positions. This prevents “brush fires” on the securities markets from
immediately triggering transactions that then have to be reversed once the markets settle down.
However, if the downward pressure on the markets intensifies, risk exposure must be gradually
reduced. The maximum volatility limit can briefly be touched or even slightly exceeded during such
phases.
Alongside this basic form, there are other different ways to limit portfolio volatility. For example,
the investor can set a volatility band within which the portfolio is allowed to move. With this
variant, limits are set on both the maximum and minimum allowable volatility. In another variation,
a classical benchmark-oriented concept can be combined with a volatility-controlled concept. This
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Performance of risk-oriented portfolio
Performance of benchmark-oriented portfolio
7. approach attaches a maximum volatility limit to a benchmark strategy. The portfolio is managed
in accordance with benchmark targets as long as the maximum portfolio volatility limit is not
exceeded. But if the limit is breached, the fluctuation bands for the more aggressive categories
of the benchmark strategy are overridden to systematically reduce risk.
Adjusting the volatility limit
The portfolio volatility limit can be set firmly or flexibly over a given period. Under the flexible option,
it is adjusted depending on the portfolio performance over the course of a given period (it is
adjusted quarterly or yearly, for example). It is therefore a multilevel volatility limit in this case. This
means that the portfolio’s performance during the course of the year is factored into the decision-
making process, with constrained risk capacity taken into account if need be. Risk capacity would
be constrained, for example, if the maximum volatility limit were to be lowered due to a return
earned in a given period. Assuming, for example, that a maximum volatility of 7% applies for a
performance down to -3%, the risk budget drops from 7% to 5% if the loss exceeds -3%.
Reducing the volatility budget lowers the loss potential because the portfolio becomes more
defensive. When the markets calm down again and volatility diminishes accordingly, the risk
budget increases, enabling the investor to participate in an upturn from that moment onward.
Such rules-based conduct avoids the problem of determining the right timing for reentering the
market or unwinding hedging strategies.
Handling the volatility limit in actual practice
When determining strategic asset allocation, the defensive cash and fixed-income asset categories
should be allowed to be assigned weightings up to 100% regardless of the set volatility limit. This
enables the portfolio to be consistently positioned defensively in a very tough market environment.
The maximum weighting of the riskier equities asset category, in contrast, depends on the volatility
limit. Alongside cash, fixed-income securities and stocks, alternative assets can also be included with
a maximum weighting of 15% or 20%, for example. The investments are made in very liquid
investment instruments in order to maintain an ability to react quickly to altered market conditions
when needed.
The two severe market corrections that occurred in summer/autumn 2008 and in 2011 frequently
inform investors’ decisions when setting volatility limits. They want to be better protected during such
stress phases but are able to cope well with minor losses in value. They accordingly set the maximum
volatility limit at a rather high level. The sensitivity of the portfolio to market events must be carefully
calibrated with the client’s expectations. Moreover, it would be unrealistic to expect that losses can
be completely prevented during stress phases while at the same time being able to achieve high
returns in rising markets.
In actual practice, it has proven successful when the effective portfolio volatility pursued by the
portfolio manager in calm market periods hovers around 25% below the maximum volatility limit. If a
maximum limit of 8% has to be adhered to, for example, the portfolio volatility normally stands at
around 6%. This provides sufficient leeway to exploit investment opportunities within the scope of the
defined investment profile. Moreover, it leaves a large enough buffer to cope with minor market
corrections with mildly elevated volatility without having to make hasty transactions. In contrast to the
target volatility approach, with this technique the portfolio manager is not constantly operating right at
the limit and therefore is not forced to maneuver hectically when the need to take action arises.
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8. Advantages of the volatility-based solution
In contrast to the benchmark-oriented investment approach, which focuses on a return target and
uses a target tracking error to determine the desired deviation from the benchmark, the volatility-
limiting concept puts loss limitation in the foreground. During stress phases with elevated
psychological pressure, the volatility-limiting concept enables investors to resort to rules that they
instated in calmer times.
Compared to the capital protection concept, the volatility-based portfolio is much more
aggressively positioned during favorable market phases, which – just like the benchmark-oriented
investment approach – enables investors to profit from market opportunities within the scope of
their personal investment profiles.
Opportunities
The investment strategy is very flexible and enables investments in the most attractive asset
categories and asset classes worldwide.
The portfolio manager ensures that the portfolio volatility stays below the limit set by the
investor.
The individual investments are made in very liquid and transparent investment instruments in
order to be able to react flexibly to changing market conditions.
Risks
The volatility-oriented approach is an investment solution aimed at containing losses, but does not
provide a guarantee against losses.
In the event of very turbulent markets, portfolio risk can briefly exceed the maximum volatility limit.
Portfolio performance depends on the correctness of the financial-market views, the right choice
of investment instruments and the level of the volatility limit.
Summary: Volatility-based investment approach
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Features
1. Market and investment views
Market and investment views are implemented with the volatility limit taken into
account.
2. Comprehensive risk control
A volatility target or limit enables portfolio risk to be efficiently and comprehensively
controlled.
3. Active investment style
It combines a risk-oriented approach (in weak markets) with a return-oriented approach
(in sideways drifting or rising markets), effectively smoothing out return performance
during substantial correction phases.
A portfolio based on the volatility-limiting investment approach is more actively managed
than a classical benchmark-oriented portfolio that employs a target tracking error.
4. Liquid and transparent investment instruments
The portfolio is invested in very liquid and transparent investment instruments in order
to be able to take action quickly and flexibly.
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4. Glossary
Correlation A measure of how prices of different asset categories or investment instruments move in
relation to each other. The correlation coefficient quantifies the strength of the relationship
as a figure ranging between –1 and +1. The closer the coefficient is to 1, the stronger the
correlation. If the coefficient is –1, the asset categories or investment instruments move
exactly in opposite directions. A coefficient of 0 indicates that there is no apparent correlation
between the asset price movements.
Floor The maximum limit below which the value of the invested capital is not allowed to fall.
Tracking error This measures the tactical asset allocation’s divergence from the strategic asset allocation
and serves as a control parameter in the benchmark-oriented investment concept.
Volatility A metric for measuring risk. Volatility measures a return’s fluctuation range around a
mean. It can be applied to an individual security (such as a stock, for instance), interest
rates, a market index or, for example, to the performance of a portfolio. The more
unsteady the return performance, the higher the volatility and thus the riskier the
investment. Volatility is therefore also regarded as a “fear barometer”.
