Graham A. Rennison, Niels K. Pedersen
Elevated global macroeconomic uncertainty and bouts of extreme market turbulence have recently plagued financial markets. This environment has prompted a search for diversifying investment opportunities that lie outside the space of traditional asset classes. This article examines the performance of options strategies that aim to capture a return premium over time as compensation for the risk of losses during sudden increases in market volatility. We show that these “volatility risk premium” strategies deliver attractive risk-adjusted returns across 14 options markets from June 1994 to June 2012. Performance furthermore improves significantly after the crisis in 2008 (see Figure 1). We conclude that the risk-return tradeoff for volatility strategies compares favorably to those of traditional investments, such as equities and bonds, and that the strategies exhibit relatively low correlations to equity risk. Investors who want to diversify their portfolio’s equity risk exposures should therefore consider making allocations to volatility risk premium strategies. However, successful implementation would require diversification across major options markets (equities, interest rates, currencies and commodities), active risk management and prudent scaling.
Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk; investments may be worth more or less than the original cost when redeemed. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. Commodities contain heightened risk including market, political, regulatory, and natural conditions, and may not be suitable for all investors. Tail risk hedging may involve entering into financial derivatives that are expected to increase in value during the occurrence of tail events. Investing in a tail event instrument could lose all or a portion of its value even in a period of severe market stress. A tail event is unpredictable; therefore, investments in instruments tied to the occurrence of a tail event are speculative. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2013, PIMCO.
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