DWS explains its barbell approach to volatility
Hedging multi-asset portfolios requires adopting a barbell approach to managing volatility risk, says DWS’s Christian Hille
Christian Hille, the co-head of multi-asset investing at DWS Investments, claims banks closing or shrinking both their volatility trading desks and unwinding associated books caused implied volatility to fall to low levels.
However, he has been able to buy protection against actual volatility cheaply for multi-asset portfolios he manages. Even though equity markets have largely risen since December, Hille says there are still “huge upside and downside risks”.
“It is very digital, so it is attractive to be long volatility,” he says. “We are running into a situation where more players are being forced into the market, so you need to take more exposure. The only way to do that sensibly is to counterbalance that with tail hedges.
“We do not expect 100% participation on the upside because you are paying for the tail hedge, but you do want 60% to 70% participation. The sensible way to do that – as there are still significant risks in the market – is to counterbalance it with hedges.”
Hille’s multi-asset funds have hedged a significant portion of their €8bn in total AUM with ‘tail risk’ strategies. These might not perform in flat or smoothly rising markets, but they should profit strongly in more volatile, sharply falling markets.
In setting these hedges, though, Hille has not used the most crowded volatility-protection trades, where herds holding similar opinions on volatility gather.
For example, he may use credit default swap (CDS) index tranches insuring credit markets for equity hedges. They do not rely on defaults or ‘credit events’ to profit. Hille can buy and sell as mark-to-market values of CDS instruments move in anticipation.
Holders of tranches of CDS pay running spreads of 20bps to 25bps. But as shares fell in August and September 2011, the positions had a PL impact of 150bps, from mark-to-market.
Hille adds that, as with many multi-asset managers these days, he frequently uses derivatives to get exposure to mainstream asset classes. “We do not always execute with Delta 1 single name stocks.”
Currently, up to 50% of equity exposure, and 10% to 20% of fixed income, is via derivatives. Hille says: “Call options, on the upside, buy positive convexity and we can buy cheaply. But on the downside, we have tail hedges.”
He adds many people use options on equities markets as a cheaper way to hedge, after the volume of long volatility ETFs spiked recently.