Five years ago, we launched a new investment strategy based on volatility control – called IsoVol – which we now use to manage more than EUR 2 billion in assets. What lessons have we learned over those five years? In particular, what is the role of the fund manager when the investment process is driven by a model monitoring volatility systematically?
The philosophy behind the IsoVol approach is partly based on our experience since the 2008 financial crisis. It became clear that depending on market conditions – from the quietest periods to the most turbulent – the volatility of an investment can change considerably, leaving investors and portfolio managers hugely uncertain of the risks involved. In early 2007, the VIX  – a measure of the implied volatility of US equities – briefly fell below the 10% mark. Less than two years later, in November 2008, it was nearing 90%.
In this context, a new model-driven investment process based on volatility was developed through close collaboration between the financial engineers at BNP Paribas Investment Partners and the management team at THEAM. Underpinning the financial modelling were teams of men and women who based their assumptions on their experience of the market.
Changing market conditions require constantly evolving strategic thought
Over the past five years, markets have felt the influence of leading central banks’ unconventional monetary policies, including Quantitative Easing (QE), which of course affected volatility. In 2012, ECB President Mario Draghi’s formula for saving the Eurozone, “Believe me, it will be enough” marked the start of an unprecedented compression of volatility across all major asset classes – equities, bonds and currency markets.
While statistically, risk declined alongside volatility, our experience lead us to question the artificiality of such low levels and the implications of risk and volatility being seen as unstable. Accordingly, we have adjusted the IsoVol model to improve the speed with which portfolio adjustments can be carried out, in particular bearing in mind the scenario of a possible abrupt rise in interest rates.
A strategy that can be reshaped to fit a flexible universe
Another important lesson was that a fixed investment universe, as defined in late 2009, is not always best suited to investment opportunities that can, by definition, quickly change due to major macroeconomic shifts. Beyond the flexibility of exposure to different asset classes, we have made the IsoVol investment universe itself more flexible. Depending on market anticipations, we are able to add up to three new types of diversification assets to the strategy that are better suited to meet the current economic challenges. For example, we invested in June 2015 in Australian government bonds, which can potentially benefit from a slowdown in GDP growth in emerging Asia.
The human factor is critical
The flexibility of the investment universe also involves the choice of instruments. Thus we constantly monitor innovations in the industry, for instance the development of ‘quanto’ products (hedged in forex) in the ETF and index fund segments.
This shows that in addition to the advantages of controlling volatility in a systematic and disciplined way, the human factor has a role to play in the management of an IsoVol strategy fund. By climbing the learning curve, model-driven management can only become more effective.
Also read the post: And what if volatility came back to town?
All sources of data as at end-July 2015, THEAM
 The VIX, which stands for Volatility Index, measures the implied volatility of S&P 500 index options. It is often referred to as the fear index.
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