differentiating and benchmarking volatility-based ... › rmc › 2016 › day-2-session-4.pdfmarch...

March 1, 2016

Differentiating and Benchmarking Volatility-Based Investment Strategies

1

Chris DeMeo, FSA, CFA, Founding Partner

Nu Paradigm Investment Partners, LLC

Discussion outline

1

• Introduction

• Importance of benchmarks

• CBOE EurekaHedge Volatility Indexes

• Trading volatility

• Performance analysis:

Return-Oriented benchmarks

Long volatility

Short volatility

Relative value

Risk Management (Tail-risk) benchmark

• Conclusion

• Contact information

Introduction

2

• Volatility has always been part of the portfolio construction dialogue,

although more often as a byproduct of investing in risky assets rather than

as an explicit opportunity for a diversified return source.

• Over the past decade, there has been a growing focus on volatility-based

strategies by investors, advisors, asset managers and academia.

• As actual and anticipated allocations to volatility-based strategies continued

to grow, an analytical framework was needed to solve this problem and

harmonize the types of volatility trading strategies

• We believe that the CBOE EurekaHedge Volatility Indexes provide a

solution to this benchmarking challenge by effectively delineating the return

source for volatility-based investments.

• The indexes provide a method for investors to benchmark these strategies

in a way that creates a more meaningful comparison and allows for

pragmatic expectations and evaluations, essential elements in effective

benchmarking.

Importance of benchmarks

3

• Before the launch of the CBOE EurekaHedge Volatility Indexes, which were

officially introduced to the market in August of 2015, investors seeking to

analyze volatility-based strategies faced great difficulty given the lack of

transparency and the absence of appropriate benchmarks.

• It was apparent that investors lacked benchmarks that allowed for more

specificity and granularity to meet their due diligence demands.

• As the volatility-based strategy asset class continued to grow, the need for

effective benchmark instruments became vital for due diligence purposes.

• The indexes currently track 77 unique strategies with combined assets

under management of over $50 billion as of 6/30/15.

CBOE EurekaHedge Volatility Indexes

4

CBOE

EurekaHedge

Index

Details

Long Volatility

The index is designed to provide a broad measure of the performance of

underlying hedge fund managers who take a net long view on implied

volatility with a goal of positive absolute return. 12 Constituents.

Short Volatility


underlying hedge fund managers who take a net short view on implied

volatility with a goal of positive absolute return. 16 Constituents.

Relative Value


underlying hedge fund managers that trade relative value or opportunistic

volatility strategies. 40 Constituents.

Tail Risk


underlying hedge fund managers that specifically seek to achieve capital

appreciation during periods of extreme market stress. 9 Constituents.

Importance of benchmarks – Key elements

5

• In order for a benchmark to be both applicable and advantageous for the

due diligence process, we believe that the SAMURAI1 methodology

provides good tenets of a benchmarking in-line with industry standards.

• The CBOE EurekaHedge Volatility Indexes aligns favorably with the

SAMURAI criteria other than the indexes are currently not directly

investable.

Specified In AdvanceThe benchmark is specified prior to the evaluation

period.

AppropriateIt is consistent with the manager’s investment style or

area of expertise.

MeasurableThe return is readily calculable on a reasonably frequent

basis.

Unambiguous Identities and weights of securities are clearly defined.

Reflective of Current Investment

Opinions

The manager has current knowledge of the securities in

the benchmark.

Accountable/OwnedThe manager should be aware and accept accountability

for the constituents and performance of the benchmark.

Investable It is possible to simply hold the benchmark.

1 Managing Investment Portfolios: A Dynamic Process (CFA Institute), Third Edition, Maginn, Tuttle, Pinto, McLeavey, 2007

Trading volatility

6

• True volatility-based strategies target a reliable source of return with lower

correlation to “traditional” asset classes over full market cycles.

• Allocations to lower correlated return sources continue to be in strong

demand by investors, although finding non-correlated assets has become

increasingly difficult.

• If we analyze how volatility is correlated to other asset classes using the

CBOE® VIX® Index as a proxy for volatility, the potential benefit of volatility’s

negative correlation is evident

• Volatility-based investment strategies have flourished as investors

seek to take advantage of this and improve portfolio efficiency.

10 Year correlation as

of 12/31/15 using VIX

Index

CBOE VIX 1.00

Barclays US Aggregate 0.15

MSCI EAFE -0.43

MSCI EM -0.31

S&P500 -0.48Data Source: CBOE, eVestment Alliance

Trading volatility

7

• Investors have also increased their desire for improved downside

protection, especially as a result of the damage to most portfolios during the

2008 financial crisis.

• The chart below depicts maximum drawdowns in 2008 for major asset

classes, as well as the CBOE EurekaHedge Volatility Indexes.

-5.00%

-0.69%

-23.22%

-6.37%

-46.59%

-56.71%

-37.66%

-60.00% -50.00% -40.00% -30.00% -20.00% -10.00% 0.00%

CBOE EH Long Volatility Index

CBOE EH Relative Value Index

CBOE EH Short Volatility Index

CBOE EH Tail Risk Index

MSCI EAFE-ND

MSCI EM-ND

S&P 500

2008 Max Drawdown

Data Source: CBOE, eVestment Alliance

Trading volatility

8

• To help investors better understand potential sources of return and

diversification, it is useful to group the volatility-based strategies:

Return-Oriented: Goal is to capture a systematic, repeatable return

premium from investing in volatility

Risk Management: Goal is to use systematic inefficiencies/pricing

discrepancies to provide cost-effective downside equity protection

Return-Oriented Objective Benchmark

Long Volatility

Alpha producer on a continual basis, favors crisis alpha,

can perform in a variety of markets, although tends to

perform best in volatile markets.

CBOE EurekaHedge

Long Volatility Index

Short VolatilityNet short view on implied volatility, higher correlation to

equities, performs best in low volatility markets.

CBOE EurekaHedge

Short Volatility Index

Relative Value

Highly dependent on mean reversion, often using spread

trades to discern where the value is and what to exploit.

Evaluate current volatility against expected volatility.

CBOE EurekaHedge

Relative Value Volatility

Index

Risk Management

Tail Risk

Asymmetric Beta to provide upside return to offset

losses in extreme market conditions. Also implemented

to enable more Delta One/Equity like exposure.

CBOE EurekaHedge Tail

Risk Index

Performance analysis: Return-Oriented - Long volatility

9

• These managers seek uncorrelated return streams with a risk/reward skew

towards systematic opportunities, but without the constant negative carry

associated with traditional tail-risk hedging.

• Long volatility exposure can provide positive return, especially during times

of market disruption although even in times of relative market calm, the

diversification, return and flexibility provided can be significant.

• The resulting return/risk ratio indicates improved return per unit of risk

7.316.50

1.125.30 5.74

0.92

7.30

14.58

0.50

Returns Since Inception Std Dev Since Inception Return/Risk

Long Volatility PerformanceSince Inception: January 2005-November 2015

CBOE EH Long Volatility Index HFN Hedge Fund Aggregate Index S&P 500


Performance analysis: Return-Oriented - Short volatility

10

• Short volatility-based strategies tend to have higher correlations with

equities given the largest component of the strategy is “long” equities.

• However, these strategies generally have lower downside risk compared to

pure long equities because they capture additional yield from the options

which helps buffer overall portfolio downside risk over a full market cycle.

• Performance of the CBOE EurekaHedge Short Volatility Index has been

strong relative to the HFN Hedge Fund Aggregate Index and the S&P500.

9.32 8.84

1.055.30 5.74

0.92

7.30

14.58

0.50


Short Volatility PerformanceSince Inception: January 2005 - November 2015

CBOE EH Short Volatility Index HFN Hedge Fund Aggregate Index S&P 500


Performance analysis: Return-Oriented - Relative value

11

• Relative Value Volatility Strategies (often referred to as “Volatility Arbitrage”)

seek to exploit pricing inefficiencies to generate consistent, absolute,

“market-neutral” returns.

• These strategies heavily rely on manager skill and experience to identify

and exploit options mispricing as do the previous volatility strategies.

• The CBOE EurekaHedge Relative Value Index was the best since inception

performer of the CBOE EurekaHedge Volatility Indexes.

10.05

3.85 2.615.30 5.74

0.92

7.30

14.58

0.50


Relative Value PerformanceSince Inception: January 2005 - November 2015

CBOE EH Relative Value Index HFN Hedge Fund Aggregate Index S&P 500


Performance analysis: Return-oriented

12

• The return-oriented CBOE EurekaHedge Volatility Indexes compare

favorably to the HFN Hedge Fund Aggregate index and the S&P500 over

the 10 year time period ending 11/30/15.

$1,641,975

$2,077,901 $2,296,300

$2,570,550

$2,057,367

HFN Hedge FundAggregate Index

CBOEEurekaHedgeLong Volatility

Index

CBOEEurekaHedgeShort Volatility

Index

CBOEEurekaHedgeRelative Value

Index

S&P 500

10 Year Growth of $1 Million Dollars



13

• Below summarize the trailing performance as of 11/30/15 for the three

return-oriented CBOE EurekaHedge Volatility Indexes.


2.05

-0.77

2.54

5.00

7.59

4.703.78

5.26

6.90

9.90

1.89

5.48 5.21

8.45 8.67

1 YEAR 3 YEAR 5 YEAR 7 YEAR 10 YEAR

Trailing PerformanceAs of 11/30/15

CBOE EH Long Volatility Index CBOE EH Relative Value Index

CBOE EH Short Volatility Index


14

• We analyzed the Sharpe Ratio (return per unit of risk) for the three CBOE

EurekaHedge Volatility Indexes compared to the S&P500

• All three indexes had significantly higher Sharpe Ratios compared to the

S&P500.

• The CBOE EurekaHedge Relative Value Volatility Index had the highest

Sharpe Ratio since inception


0.92

2.26

0.90

0.41

CBOE EH LongVolatility Index

CBOE EH RelativeValue Index

CBOE EH ShortVolatility Index

S&P500

Risk Adjusted Return:Since Inception Sharpe Ratio

Performance analysis: Risk Management (Tail-Risk)

15

• Tail Risk volatility-based strategies can increase overall portfolio efficiency

by allowing an investor to continue to maintain their long-term return

objective while providing extreme market downside protection.

• Investors who employ a tail risk strategy are willing to accept small losses

(“insurance premium”) during periods of low volatility in exchange for the

“insurance benefit” of significant upside potential during periods of

heightening market volatility.

• Employing a tail risk strategy can allow for an increased equity/delta-one

exposure to offset some or all of the tail risk “insurance premium”.

• When viewed as part of a diversified portfolio over a full market cycle, these

strategies can provide significantly improved portfolio efficiency and deliver

compelling downside protection.

• As seen below, the CBOE EurekaHedge Tail Risk Index provided strong

returns during down markets over the seven year period as of 11/30/15

Up Market Capture 7

Years using S&P500

Down Market Capture 7

Years using S&P500

CBOE EurekaHedge Tail Risk Index -28.86 -58.32

HFN Hedge Fund Aggregate Index 30.95 30.82


Performance analysis: Risk Management (Tail-Risk)

16

• Below highlights the performance of the CBOE EurekaHedge Tail Risk

Index during shocks such as October 2008, August 2011 and August 2015.

• When viewed in insolation, especially in upward moving markets, it may be

more difficult to appreciate the value of a tail risk strategy.

• Tail risk strategies should be viewed in the context of an aggregate portfolio

to better understand the potential for improved portfolio efficiency

0

10

20

30

40

50

60

70

-20-15-10

-505

1015202530

CBOE EurekaHedge Tail Risk Index. vs. S&P 500 & VIXMonthly Returns: January 2008 - November 2015

CBOE EurekaHedge Tail Risk Index S&P500 VIX


Conclusion

17

• Market volatility manifested through financial instrument pricing (and

mispricing) offers unique and potentially attractive investment opportunities.

• Volatility-based strategies can enhance investment portfolios by providing

diversified return and risk management techniques.

• Efficient implementation requires a total portfolio perspective, appropriate

benchmarks and ongoing monitoring.

• Volatility strategies are distinct and non-homogeneous, making it critical to

segregate into separate categories to effectively analyze and properly

benchmark performance.

• The CBOE EurekaHedge Volatility Indexes were specifically created to

address this challenge and, based on our analysis, we strongly believe they

provide a robust and innovative solution to volatility-based strategy

benchmarking and due diligence.

Contact information

18

Chris DeMeo FSA, CFA

Founding Partner

Nu Paradigm Investment Partners, LLC

60 State Street, Suite 700

Boston, MA 02109

917-776-6956 (direct)

[email protected]

www.nupinv.com

About Nu Paradigm Investment Partners, LLC

Nu Paradigm Investment Partners, LLC is an investment advisory and OCIO firm

built to help investors solve their toughest portfolio challenges and achieve the

success that they and their beneficiaries deserve. We have provided investment

counsel and portfolio implementation to corporate and public retirement plans,

family offices, endowments, foundations, insurance companies and RIAs with

assets ranging from $10 million to $50 billion, including Fortune 500 companies.

We deliver individually-tailored solutions that can range from strategic advice, to

implementation for certain asset classes, to full outsourcing – all with a strong

emphasis on reducing total costs. Nu Paradigm clients stand to benefit from the

Partners’ global, multifaceted experience in capital markets and investment

management including both traditional and alternative investments.

http://www.nupinv.com/

Disclosure

19

This document is based on information available to Nu Paradigm at the date of issue, and takes no account of subsequent

developments after that date. In addition, past performance is not indicative of future results. In producing this document, Nu

Paradigm has relied upon the accuracy and completeness of certain data and information obtained from third parties.

The information presented is solely to report on investment strategies and opportunities identified by Nu Paradigm. Opinions and

estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends,

which are based on current market conditions. No representation is being made that any investment will or is likely to achieve a

performance record similar to that shown. Nu Paradigm and CBOE believe the information provided herein is reliable, but do not

warrant its accuracy or completeness. This material is not intended as an offer or solicitation for the purchase or sale of any

financial instrument. The views and strategies described may not be suitable for all investors. Options involve risk and are not

suitable for all investors. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of

Standardized Options. Copies are available from your broker or from The Options Clearing Corporation at www.theocc.com.

Neither Nu Paradigm nor CBOE provides legal, tax and/or accounting advice or services. Clients should consult with their own tax

or legal advisor prior to entering into any transaction or strategy described herein. Charts, graphs and other visual presentations

and text information were derived from internal, proprietary, and/ or service vendor technology sources and/or may have been

extracted from other firm data bases. As a result, the tabulation of certain reports may not precisely match other published data.

Data may have originated from various sources. Nu Paradigm and CBOE make no representation or endorsement concerning the

accuracy or propriety of information received from any other third party.

Eurekahedge Pte. Ltd. ("Eurekahedge") calculates and disseminates the CBOE Eurekahedge Volatility Indexes. CBOE is not

affiliated with Eurekahedge. The number of funds within each of the CBOE Eurekahedge Volatility Indexes can vary throughout a

month as funds disseminate returns. CBOE®, CBOE Volatility Index® and VIX® are registered trademarks and BXM, BuyWrite,

PUT and PutWrite are service marks of CBOE. All other trademarks and service marks are the property of their respective owners.

This document may not be reproduced or distributed to any other party, whether in whole or in part, without Nu Paradigm’s and

CBOE’s prior written permission, except as may be required by law. In the absence of such express written permission to the

contrary, Nu Paradigm, CBOE, their affiliates and their respective directors, officers, employees and third party providers of

information accept no responsibility and will not be liable for any consequences howsoever arising from any use of or reliance on

the contents of this document including any opinions expressed herein.

No part of this Document may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic,

mechanical, photocopying, recording or otherwise, without the prior written permission of Nu Paradigm and CBOE.

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