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.
Volatility has always been part of the portfolio construction dialogue, although more often as a by-product 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. Investors began the new millennium with the tech bubble and ended the decade recovering from the 2008 financial crisis, creating a surge in demand for more diversified, risk-managed investment solutions to mitigate volatility and improve overall portfolio efficiency.
The word ‘volatility’ often conjures negative reactions, with many investors associating the word with risk, loss, and unpredictability. In fact, unexpected and ‘uncompensated’ (i.e. insufficient return relative to risk) volatility can wreak havoc on investors, especially institutions with portfolios linked to benefit distributions, predicted liabilities or forecasted payouts, such as pension plans, insurance pools, and endowments. This has increased investor focus on strategies that can enhance portfolio returns and provide improved diversification during periods of extreme market volatility, particularly via hedge funds. With this increase in popularity of hedge fund strategies, it has become increasingly important for investors to create and maintain an effective means to monitor and evaluate performance.
In general, performance measurement for hedge fund investors is challenging, especially with the ongoing rise in the number of hedge funds and the wide range of strategies employed. As such, institutional investors continue to examine the validity and representation of available hedge fund benchmarks. However, the lack of consistent methodology and construction has complicated the due diligence process by making it difficult for investors to gauge how a manager has performed relative to a truly representative index. The surge in volatility-based hedge funds has further brought the benchmarking issue to light, particularly given that, until recently, suitable benchmarks were difficult to find.
More specifically, volatility-based hedge fund indexes that do not reflect the fundamental differences in the various volatility strategies are inadequate for investors seeking to effectively assess and implement these types of strategies. Each strategy has different return characteristics depending on the market environment. For example, comparing a tail risk volatility manager’s performance to the amalgamated returns of disparate strategies would not help an investor evaluate the efficacy of including a tail risk strategy in their overall portfolio. Each volatility-based strategy offers unique characteristics and distinctive potential advantages within a portfolio and therefore demand separate, representative benchmarks.
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 with the philosophies of the different approaches. 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. By categorizing volatility strategies into four distinct categories, this unique and innovative approach allows for more precise benchmarks that further enhance the due diligence process.
The CBOE Eurekahedge Volatility Indexes are offered in four distinct buckets that include:
- CBOE Eurekahedge Long Volatility Index
- CBOE Eurekahedge Short Volatility Index
- CBOE Eurekahedge Relative Value Volatility Index
- CBOE Eurekahedge Tail Risk Index
The categorization of the indexes in these unique classes allows investors to properly measure and evaluate volatility-based hedge funds within the bands of their respective approaches. The indexes provide a method for investors to benchmark these strategies in a way that marries the volatility trading and investment approach with its specific expected performance. This distinction creates a more meaningful comparison and allows for pragmatic expectations and evaluations, essential elements in effective benchmarking.
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