Differentiating and Benchmarking Volatility-Based ...

Differentiating and Benchmarking
Volatility-Based Investment Strategies

Chris DeMeo, FSA, CFA, Founding Partner
Nu Paradigm Investment Partners, LLC

March 1, 2016

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Discussion outline

• Introduction

• Importance of benchmarks

• CBOE EurekaHedge Volatility Indexes

• Trading volatility

• Performance analysis:
 Return-Oriented benchmarks
 Long volatility
 Short volatility
 Relative value
 Risk Management (Tail-risk) benchmark

• Conclusion

• Contact information

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Introduction

• Volatility has always been part of the portfolio construction dialogue,
although more often as a byproduct 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.

• 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

• 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.

• The indexes provide a method for investors to benchmark these strategies
in a way that creates a more meaningful comparison and allows for
pragmatic expectations and evaluations, essential elements in effective
benchmarking.

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Importance of benchmarks

• Before the launch of the CBOE EurekaHedge Volatility Indexes, which were
officially introduced to the market in August of 2015, investors seeking to
analyze volatility-based strategies faced great difficulty given the lack of
transparency and the absence of appropriate benchmarks.

• It was apparent that investors lacked benchmarks that allowed for more
specificity and granularity to meet their due diligence demands.

• As the volatility-based strategy asset class continued to grow, the need for
effective benchmark instruments became vital for due diligence purposes.

• The indexes currently track 77 unique strategies with combined assets
under management of over $50 billion as of 6/30/15.

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CBOE EurekaHedge Volatility Indexes

CBOE Details
EurekaHedge
Index The index is designed to provide a broad measure of the performance of
underlying hedge fund managers who take a net long view on implied
Long Volatility volatility with a goal of positive absolute return. 12 Constituents.

Short Volatility The index is designed to provide a broad measure of the performance of
underlying hedge fund managers who take a net short view on implied
volatility with a goal of positive absolute return. 16 Constituents.

Relative Value The index is designed to provide a broad measure of the performance of
underlying hedge fund managers that trade relative value or opportunistic
volatility strategies. 40 Constituents.

Tail Risk The index is designed to provide a broad measure of the performance of
underlying hedge fund managers that specifically seek to achieve capital
appreciation during periods of extreme market stress. 9 Constituents.

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Importance of benchmarks – Key elements

• In order for a benchmark to be both applicable and advantageous for the
due diligence process, we believe that the SAMURAI1 methodology
provides good tenets of a benchmarking in-line with industry standards.

Specified In Advance The benchmark is specified prior to the evaluation
period.
Appropriate It is consistent with the manager’s investment style or
area of expertise.
Measurable The return is readily calculable on a reasonably frequent
Unambiguous basis.
Reflective of Current Investment
Opinions Identities and weights of securities are clearly defined.

The manager has current knowledge of the securities in
the benchmark.

Accountable/Owned The manager should be aware and accept accountability
for the constituents and performance of the benchmark.

Investable It is possible to simply hold the benchmark.

• The CBOE EurekaHedge Volatility Indexes aligns favorably with the
SAMURAI criteria other than the indexes are currently not directly
investable.

1 Managing Investment Portfolios: A Dynamic Process (CFA Institute), Third Edition, Maginn, Tuttle, Pinto, McLeavey, 2007

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Trading volatility

• True volatility-based strategies target a reliable source of return with lower
correlation to “traditional” asset classes over full market cycles.

• Allocations to lower correlated return sources continue to be in strong

demand by investors, although finding non-correlated assets has become

increasingly difficult.
• If we analyze how volatility is correlated to other asset classes using the

CBOE® VIX® Index as a proxy for volatility, the potential benefit of volatility’s

negative correlation is evident

10 Year correlation as

of 12/31/15 using VIX

Index

CBOE VIX 1.00

Barclays US Aggregate 0.15

MSCI EAFE -0.43

MSCI EM -0.31

S&P500 -0.48

Data Source: CBOE, eVestment Alliance

• Volatility-based investment strategies have flourished as investors

seek to take advantage of this and improve portfolio efficiency.

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Trading volatility

• Investors have also increased their desire for improved downside
protection, especially as a result of the damage to most portfolios during the
2008 financial crisis.

• The chart below depicts maximum drawdowns in 2008 for major asset
classes, as well as the CBOE EurekaHedge Volatility Indexes.

2008 Max Drawdown

S&P 500 -37.66%

MSCI EM-ND -56.71%

MSCI EAFE-ND -46.59%
CBOE EH Tail Risk Index
-6.37%
CBOE EH Short Volatility Index -23.22%

CBOE EH Relative Value Index -0.69%
-5.00%
CBOE EH Long Volatility Index -20.00% -10.00% 0.00%

-60.00% -50.00% -40.00% -30.00%
Data Source: CBOE, eVestment Alliance

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Trading volatility

• To help investors better understand potential sources of return and
diversification, it is useful to group the volatility-based strategies:
 Return-Oriented: Goal is to capture a systematic, repeatable return
premium from investing in volatility
 Risk Management: Goal is to use systematic inefficiencies/pricing
discrepancies to provide cost-effective downside equity protection

Return-Oriented Objective Benchmark
Long Volatility
Alpha producer on a continual basis, favors crisis alpha, CBOE EurekaHedge
Short Volatility can perform in a variety of markets, although tends to Long Volatility Index
perform best in volatile markets.
Relative Value
Risk Management Net short view on implied volatility, higher correlation to CBOE EurekaHedge
Tail Risk
equities, performs best in low volatility markets. Short Volatility Index

Highly dependent on mean reversion, often using spread CBOE EurekaHedge

trades to discern where the value is and what to exploit. Relative Value Volatility

Evaluate current volatility against expected volatility. Index

Asymmetric Beta to provide upside return to offset CBOE EurekaHedge Tail
losses in extreme market conditions. Also implemented Risk Index
to enable more Delta One/Equity like exposure.

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Performance analysis: Return-Oriented - Long volatility

• These managers seek uncorrelated return streams with a risk/reward skew
towards systematic opportunities, but without the constant negative carry
associated with traditional tail-risk hedging.

• Long volatility exposure can provide positive return, especially during times
of market disruption although even in times of relative market calm, the
diversification, return and flexibility provided can be significant.

• The resulting return/risk ratio indicates improved return per unit of risk

Long Volatility Performance
Since Inception: January 2005-November 2015

CBOE EH Long Volatility Index HFN Hedge Fund Aggregate Index S&P 500

14.58

7.31 7.30 6.50 5.74
5.30

Returns Since Inception Std Dev Since Inception 1.12 0.92 0.50
Data Source: CBOE, eVestment Alliance Return/Risk

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Performance analysis: Return-Oriented - Short volatility

• Short volatility-based strategies tend to have higher correlations with
equities given the largest component of the strategy is “long” equities.

• However, these strategies generally have lower downside risk compared to
pure long equities because they capture additional yield from the options
which helps buffer overall portfolio downside risk over a full market cycle.

• Performance of the CBOE EurekaHedge Short Volatility Index has been
strong relative to the HFN Hedge Fund Aggregate Index and the S&P500.

Short Volatility Performance
Since Inception: January 2005 - November 2015

CBOE EH Short Volatility Index HFN Hedge Fund Aggregate Index S&P 500

14.58

9.32 8.84
7.30
5.74
5.30
1.05 0.92 0.50
Returns Since Inception Std Dev Since Inception
Return/Risk

Data Source: CBOE, eVestment Alliance

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Performance analysis: Return-Oriented - Relative value

• Relative Value Volatility Strategies (often referred to as “Volatility Arbitrage”)
seek to exploit pricing inefficiencies to generate consistent, absolute,
“market-neutral” returns.

• These strategies heavily rely on manager skill and experience to identify
and exploit options mispricing as do the previous volatility strategies.

• The CBOE EurekaHedge Relative Value Index was the best since inception
performer of the CBOE EurekaHedge Volatility Indexes.

Relative Value Performance
Since Inception: January 2005 - November 2015

CBOE EH Relative Value Index HFN Hedge Fund Aggregate Index S&P 500

14.58

10.05 7.30 5.74
5.30 3.85

Returns Since Inception Std Dev Since Inception 2.61 0.92 0.50

Return/Risk

Data Source: CBOE, eVestment Alliance

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Performance analysis: Return-oriented

• The return-oriented CBOE EurekaHedge Volatility Indexes compare
favorably to the HFN Hedge Fund Aggregate index and the S&P500 over
the 10 year time period ending 11/30/15.

10 Year Growth of $1 Million Dollars

$2,570,550

$2,296,300

$2,077,901 $2,057,367

$1,641,975

HFN Hedge Fund CBOE CBOE CBOE S&P 500
Aggregate Index EurekaHedge EurekaHedge EurekaHedge
Long Volatility Short Volatility Relative Value

Index Index Index

Data Source: CBOE, eVestment Alliance

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Performance analysis: Return-oriented

• Below summarize the trailing performance as of 11/30/15 for the three
return-oriented CBOE EurekaHedge Volatility Indexes.

Trailing Performance
As of 11/30/15

8.45 9.90
6.90
8.67
5.00 7.59

4.70 5.48 5.26 5.21
3.78 2.54
2.05 1.89
-0.77

1 YEAR 3 YEAR 5 YEAR 7 YEAR 10 YEAR

CBOE EH Long Volatility Index CBOE EH Relative Value Index
CBOE EH Short Volatility Index

Data Source: CBOE, eVestment Alliance

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Performance analysis: Return-oriented

• We analyzed the Sharpe Ratio (return per unit of risk) for the three CBOE
EurekaHedge Volatility Indexes compared to the S&P500

• All three indexes had significantly higher Sharpe Ratios compared to the
S&P500.

• The CBOE EurekaHedge Relative Value Volatility Index had the highest
Sharpe Ratio since inception

Risk Adjusted Return:
Since Inception Sharpe Ratio

2.26

0.92 0.90

CBOE EH Long CBOE EH Relative CBOE EH Short 0.41
Volatility Index Value Index Volatility Index S&P500

Data Source: CBOE, eVestment Alliance

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Performance analysis: Risk Management (Tail-Risk)

• Tail Risk volatility-based strategies can increase overall portfolio efficiency

by allowing an investor to continue to maintain their long-term return

objective while providing extreme market downside protection.
• Investors who employ a tail risk strategy are willing to accept small losses

(“insurance premium”) during periods of low volatility in exchange for the
“insurance benefit” of significant upside potential during periods of

heightening market volatility.
• Employing a tail risk strategy can allow for an increased equity/delta-one

exposure to offset some or all of the tail risk “insurance premium”.
• When viewed as part of a diversified portfolio over a full market cycle, these

strategies can provide significantly improved portfolio efficiency and deliver

compelling downside protection.
• As seen below, the CBOE EurekaHedge Tail Risk Index provided strong

returns during down markets over the seven year period as of 11/30/15

CBOE EurekaHedge Tail Risk Index Up Market Capture 7 Down Market Capture 7
HFN Hedge Fund Aggregate Index Years using S&P500 Years using S&P500
-58.32
-28.86 30.82
30.95

Data Source: CBOE, eVestment Alliance

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Performance analysis: Risk Management (Tail-Risk)

• Below highlights the performance of the CBOE EurekaHedge Tail Risk
Index during shocks such as October 2008, August 2011 and August 2015.

CBOE EurekaHedge Tail Risk Index. vs. S&P 500 & VIX
Monthly Returns: January 2008 - November 2015

30 CBOE EurekaHedge Tail Risk Index S&P500 VIX 70
60
25 50
40
20 30
20
15 10
0
10

5

0

-5

-10

-15

-20

Data Source: CBOE, eVestment Alliance

• When viewed in insolation, especially in upward moving markets, it may be

more difficult to appreciate the value of a tail risk strategy.
• Tail risk strategies should be viewed in the context of an aggregate portfolio

to better understand the potential for improved portfolio efficiency

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Conclusion

• 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.

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Contact information 60 State Street, Suite 700
Boston, MA 02109
Chris DeMeo FSA, CFA
Founding Partner 917-776-6956 (direct)
Nu Paradigm Investment Partners, LLC [email protected]
www.nupinv.com

About Nu Paradigm Investment Partners, LLC
Nu Paradigm Investment Partners, LLC is an investment advisory and OCIO firm
built to help investors solve their toughest portfolio challenges and achieve the
success that they and their beneficiaries deserve. We have provided investment
counsel and portfolio implementation to corporate and public retirement plans,
family offices, endowments, foundations, insurance companies and RIAs with
assets ranging from $10 million to $50 billion, including Fortune 500 companies.
We deliver individually-tailored solutions that can range from strategic advice, to
implementation for certain asset classes, to full outsourcing – all with a strong
emphasis on reducing total costs. Nu Paradigm clients stand to benefit from the
Partners’ global, multifaceted experience in capital markets and investment
management including both traditional and alternative investments.

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Disclosure

This document is based on information available to Nu Paradigm at the date of issue, and takes no account of subsequent
developments after that date. In addition, past performance is not indicative of future results. In producing this document, Nu
Paradigm has relied upon the accuracy and completeness of certain data and information obtained from third parties.

The information presented is solely to report on investment strategies and opportunities identified by Nu Paradigm. Opinions and
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