Implementing LDI with swaptions - Russell Investments

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STRATEGY TIMING IMPLEMENTATION CLIENT FOCUS Volatility-responsive asset allocation: The results in practice By: Bob Collie, FIA, Chief Research Strategist, Mike Sylvanus, Senior Investment Strategist, and Michael Thomas, CFA, Head of Consulting and Chief Investment Officer Bob Collie In last quarter’s issue of Communiqué, Mike Thomas explained how volatility is itself variable over time and how an investment policy might be designed that responds to those variations. This quarter we look at how such a policy would have performed—at the impact on the risk and returns of following a volatility-responsive strategy. Mike Sylvanus Michael Thomas Reducing volatility and improving the risk/return trade-off The principle that underpins volatility-responsive asset allocation is to reduce exposure to risky assets when volatility is high, and to increase that exposure when volatility is low. Volatility is an appealing foundation for a dynamic strategy because, unlike the outlook for returns (which are notoriously difficult to forecast), we can be relatively confident in our assessment of the volatility environment. One reason for this confidence is that changes in volatility are more persistent than changes in returns: Even a simple look at recent returns gives us useful insight about the immediate volatility environment. There are other ways to gauge the volatility environment: the volatility implied by options prices, for example, or the volatility of other markets. The analysis that follows is based on two assets only: U.S equity and U.S. fixed income, as represented by the Russell 3000 ® Index and the Barclays Capital U.S. Aggregate Bond Index (see Exhibit 1 for reference). It covers the period April 1979–June 2011, the period for which data on the Russell 3000 is available (the data starts at January 1979, and the strategy starts once 60 days’ return data is available from which to calculate trailing volatility). At the start of each month, the volatility of the daily equity market returns for the previous 60 trading days is calculated. If that volatility lies in the range 10.3%–16.9%, then a notrade zone applies; this level of volatility is not regarded as being unusual enough to merit a deviation from the default asset allocation of 50% equity/50% fixed income. (This range was chosen so that the no-trade zone applies half of the time.) As volatility rises beyond 16.9%, the allocation to risky assets is decreased. Conversely, as volatility falls below 10.3%, the allocation to risky assets is increased. Note that the size of the no-trade zone, the minimum and maximum allocations to risky assets and the rate at which those minimum and maximum positions are achieved are parameters that can be customized to the specific situation. Our analysis confirms that this strategy does indeed produce lower volatility than the fixed mix, and its volatility is more stable and predictable. However, this is only half of the story. Russell Investments // Russell Communiqué p / 8
RUSSELL INVESTMENTS CLIENT FOCUS (continued) Asset allocation is not about risk alone, but about the trade-off between risk and expected return. If the rewards for taking risk are highest at the times of high market volatility, then the reduction in volatility shown above would come at too high a price: a drop in returns that more than wipes out the risk benefit. Here, too, the strategy stands up well: there was no return penalty over the period analyzed; the volatilityresponsive strategy delivered an average 40 basis points higher return after accounting for trading costs. The full results are summarized in the table below, which compares the return pattern of the volatility-responsive strategy to that of a fixed 50/50 mix. Let us consider each of these statistics in turn. Annualized return: Even allowing for the cost of trading, the volatility-responsive strategy delivered a return over the full period that not only matched but beat that of the fixed mix. Note, however, that this can be episodic: there are periods of reduced return as well as periods of enhanced return. Annualized standard deviation: For the reasons described in the previous Communiqué article, we would expect the volatility-responsive strategy to deliver a more stable return stream than the fixed mix, and this was indeed the case. Note that not only is the standard deviation of returns over the full period lower, but the variability of the standard deviation over short periods is also materially lower, as shown in Exhibit 2. 5%ile monthly return: Roughly one in 20 of the monthly returns were –3.05% or worse under the volatility-responsive strategy, while roughly one in 30 were –3.41% or worse under the fixed mix. Thus, using this as a definition of a bad-case scenario, the volatility-responsive strategy fares slightly better, mitigating downside risk. Worst monthly return: A more extreme bad-case scenario is provided by a look at the lowest monthly return. For the volatility-responsive strategy, this would have occurred in October 1987, when the portfolio value fell by 9.44%. (As a point of comparison, in that month the fixed-mix value fell by 9.43%.) The worst month for the fixed mix was October 2008, when it fell by 10.05%. (By comparison, the volatility-responsive strategy fell by 5.44% that month.) Worst three-month return: For the volatility-responsive strategy, this was a September through November 1987 decline of 12.16%. (As a point of comparison, over that same period, the 50/50 fixed mix declined by 14.37%.) The worst three-month return for the fixed mix, a loss of 16.86%, occurred in September through November 2008. (By comparison, the volatilityresponsive strategy would have declined by 8.77% over that three-month period.) In summary, then, each of the measures points to the volatility-responsive strategy Exhibit 1: Summary statistics of volatility-responsive strategy, April 1979–June 2011 Fixed mix (50% equity) Volatility-responsive strategy Annualized return 10.28% 10.68% Annualized standard deviation 8.99% 8.43% 5%ile monthly return –3.41% –3.05% Worst monthly return –10.05% –9.44% Worst three-month return –16.86% –12.16% Indexes are unmanaged and cannot be invested in directly. Past performance is not indicative of future results. p / 9
Page 1 and 2: Fourth Quarter 2011 Russell Communi
Page 3 and 4: EXECUTIVE VIEW Dealing with change:
Page 5 and 6: RUSSELL INVESTMENTS In today’s lo
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Page 13 and 14: RUSSELL INVESTMENTS Q&A (continued)
Page 15 and 16: RUSSELL INVESTMENTS Nothing contain

Implementing LDI with swaptions - Russell Investments

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