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The Price of Managing Volatility

Do riders with volatility controls cost VA investors potential gains?

Rajneesh Motay, 07/02/2013

This article originally appeared in the June/July 2013 issue of MorningstarAdvisor magazine. To subscribe, please call 1-800-384-4000.

Insurers are increasingly limiting investment options in their variable annuities that have riders to strategies with built-in volatility management. Volatility overlays mitigate the risks for insurance companies by embedding some hedging within the investment strategy. But are investors who buy the riders giving up a portion of potential gains in return? We investigate this question by comparing two contracts with similar benefits; one with a volatility control overlay and one without an overlay.

Targeting Risk
Most asset-allocation offerings use the percentage of stocks to serve as a proxy for risk. These are commonly billed as “target-risk funds.” A “conservative” target-risk fund typically holds between 20% and 50% of its assets in stocks; moderate, moderate growth, and growth options are analogously defined as portfolios with increasing amounts of equity exposure. This approach to investment- risk classification is reasonable because a portfolio gets more volatile as the percentage of stocks it holds increases. But risk here is understood in relative terms. Where this classification system falls short is in ignoring the absolute level of volatility. Exhibit 1 charts the rolling 30-day standard deviation of a “moderate” target-risk portfolio. It shows that the realized volatility was far from “moderate” during the difficult markets of 2008–2009, when standard deviation reached a high of 40%, a level of volatility that would have been unexpected even from an aggressive portfolio.

That experience was an unpleasant surprise to most investors, and it drove many investment firms to explore approaches that might provide a much smoother investor experience. Insurance companies had even more reason to explore alternative approaches to managing their underlying subaccounts: As portfolio volatility increased, so did the cost of hedging guarantees accompanying the investments. The insurers had effectively sold options and needed ways of managing the associated risk. The higher the unpredictability (or standard deviation) of the underlying investment, the higher the risk of an option sold on it.

Targeting Volatility
The equity weight within a two-asset portfolio that meets a volatility target is the ratio of the volatility target to the forecasted volatility of the risky asset:

where Wis the weight in equities, is the target volatility, and is the forecasted equity volatility. Correlation between the two assets and volatility of the second asset is assumed to be zero. According to this equation, to maintain constant portfolio volatility level, the weight in equities should decrease when forecasted volatility goes up and increase when forecasted volatility goes down.

Rajneesh Motay, CFA, is a senior investment consultant with the Morningstar Investment Management division.

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