EDHEC: Diversify Equity Portfolios With Volatility Derivatives

(June 6, 2012) — Investors should look into diversifying equity portfolios with volatility derivatives, research by the EDHEC-Risk Institute concludes.

Interest has grown in the possible use of equity volatility derivatives as diversifiers for traditional and alternative portfolios, according to a paper titled “The Benefits of Volatility Derivatives in Equity Portfolio Management” published by the institute.

The research shows how volatility derivatives can be used to engineer equity portfolios with downside-risk protection. “This research proposes a novel approach to the design of attractive equity solutions with managed volatility, based on mixing a well-diversified equity portfolio with volatility derivatives, as opposed to minimizing equity volatility through minimum variance approaches, and shows that trading in volatility index futures or options can provide access to the equity risk premium while allowing for explicit management of the volatility risk budget,” Noël Amenc, Director of EDHEC-Risk Institute, said in a release.

The research’s key findings include the following:

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1) A long volatility position shows a strongly negative correlation with the underlying equity portfolio. Meanwhile, adding a long volatility exposure to an equity portfolio results in improvement of the risk-adjusted performance of the portfolio.

2) The benefits of the long volatility exposure are found to be the strongest in market downturns, when they are needed the most.

3) The benefits of adding volatility exposure to equity portfolios are also found to be robust with respect to the introduction of trading costs associated with rolling over volatility derivatives contracts.

Read the full paper here.

EDHEC’s paper follows recent research by Towers Watson that found that derivatives may become too costly and too complex for some pension funds to want to use. High fees and complex counterparty structures may drive institutional investors away from using derivatives, the research suggested. In the paper entitled “Is This the End of OTC Derivatives for Pension Schemes?” Towers Watson laid out how changes in regulation and market attitude to these investment tools will make it more costly and complicated for investors to use these investing vehicles.

Decisive votes in San Diego and San Jose to lessen the burden of public sector pensions may prove a bellwether for public plans across the United States.

(June 6, 2012) — The Californian cities of San Diego and San Jose have voted overwhelmingly to overhaul their public sector pensions, passing two referendums that, while different in scope, aim to slow the cities’ soaring price of retirement benefits.

Occurring as they did on the same day as the people of Wisconsin voted to retain Governor Scott Walker, whose recall was largely seen as catalyzed by his efforts to trim the collective bargaining rights of public sector unions and require a higher contribution to worker pensions, the results may offer a foretaste of what some observers have seen as a nationwide trend to contain burgeoning retirement costs by cutting benefits.

In San Diego, voters passed the pension measure, known as Proposition B, by a 2-to-1 margin. The reform would introduce a 401(k) style retirement plan for most new public employees and would also freeze pensionable pay for a 5-year period. Implementing the plan could save the city anywhere from $500 million to $2.1 billion over 30 years.

The proposal in San Jose, dubbed Measure B, passed by an equally wide margin, would provide for a more sweeping pension reform, affecting the benefits of current as well as future public employees. If it survives an inevitable legal challenge, Measure B would force workers to choose between reduced benefits or paying more for their existing plans, shift much of the cost of retirement benefits for future hires to the worker, require pension increases to be approved by voters, and tweak marginal benefits so as to limit costs. According to the Mercury News, San Jose’s yearly pension bill has increased over the past decade from $73 million to $245 million.

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California’s state pension schemes, principally California Public Employees Retirement Systems (CalPERS) and California State Teachers’ Retirement System (CalSTRS), face as much as a half a trillion dollar unfunded liability, an April 2010 Stanford University study concluded. Municipality pension shortfalls across the state further add to that figure by many billions of dollars.

“This is going to encourage other jurisdictions in California to follow San Jose’s lead,” Joe Nation, a public policy professor at Stanford University, told the Wall Street Journal. “Pensions are the biggest challenge facing the state and local governments.”

Coming on the heels of municipal bankruptcies in Alabama and Rhode Island, exacerbated by unaffordable pension benefits, the success of these twin referendums in California may demonstrate to other ailing municipalities that pension reforms are not the electoral poison that they were long assumed to be.