Asset Management Research - December 19, 2011

Structured Equity Investment Strategies for Long-Term Asian Investors

This publication presents the results of the latest research on structured forms of investment strategies done at EDHEC-Risk Institute with the support of Societe Generale Corporate & Investment Banking and under the leadership of Stoyan Stoyanov, Head of Research at EDHEC Risk Institute–Asia and Professor of Finance at EDHEC Business School.

The current macroeconomic and regulatory environments are extremely challenging for institutional investors. Prudential and accounting standards encourage investors to invest in low risk assets that are highly correlated with liabilities. At the same time, investors operate in a low interest rate environment where attractive risk premia are offered by asset classes that are poorly correlated with liabilities or command high capital charges due to their volatility. The conundrum for long-term institutional investors is how to extract risk premia while limiting exposure to downside risks.

Structured investments allowing investors to gain access to the upside potential of an asset and at the same time providing protection on the downside could play a significant role in addressing these challenges. Ground-breaking research by EDHEC-Risk Institute found that long-term static investors should allocate a sizable fraction of their assets to portfolio insurance strategies, which can be accessed in a buy-and-hold manner via structured investment strategies. The research presented in this publication extends this earlier work in two important directions.

First, it looks at the control of volatility as an objective and assesses various strategies to pursue this objective. From a theoretical standpoint, a constant volatility portfolio is a key building block for asset allocation in a dynamic setting with stochastic volatility. Such a portfolio can also be used to efficiently deal with the problem of extreme risk arising from stochastic volatility. From a practical standpoint, there is increased demand for volatility targeting in the wake of recent market disorders as investors recognise that diversification is not a tool for downside risk control and that traditional portfolio insurance strategies do not explicitly aim at volatility control and as such may be sub-optimal tools to reduce regulatory capital consumption for market risk.

Second, it focuses on Asian markets and investors, an area where practitioner interest meets a dearth of academic research. Asian equity investing is particularly attractive given the Asian growth story and on the back of the shifting balance of economic power. At the same time, it is particularly challenging from a volatility control point of view: Asian equity markets are more volatile than their counterparts in the developed markets of Europe and North America and volatility risk is hard to hedge due to the limited availability of local volatility derivatives. However, with the region’s equity derivatives markets having developed briskly, designing and managing equity structured products is perfectly feasible for investment banks; structuring volatility targeted equity strategies for Asia is one way to address the conundrum faced by institutional investors. This publication evaluates such strategies within the framework of a stochastic volatility model that has been fitted to Asian data and captures deviations from normality exhibited by equity returns.

The research results presented in this publication show that a structured target-volatility strategy significantly improves both the downside and the upside of the return distribution relative to a fixed-mix strategy and also allows investors to benefit more from the upside potential when a capital guarantee overlay is applied. It shows how the explicit management of volatility reduces the cost of the capital protection. It also documents utility gains for risk-averse investors, with and without capital guarantee overlay, and makes the case for significant allocations to structured equity investment strategies with volatility targeting. These results have important practical implications for long-term investors, first of all for insurance companies implementing new solvency frameworks, which need to access the equity risk premium while controlling for downside risk and minimising capital consumption. While presented in the context of Asian equity markets, these results are of general applicability and could be used in other regions and for asset classes exhibiting comparable dynamics.

This study was produced as part of a research programme on structured forms of investment strategies in partnership with Societe Generale Corporate & Investment Banking.

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