Merrill Lynch Global Research has introduced a new index with exposure to equity volatility, the Merrill Lynch US Forward Equity Variance Rolling (FEVR) Index, which measures the performance of a long S&P 500 volatility strategy designed to be both tradable and efficient.
Because of the tendency of volatility to strengthen when equity markets weaken, volatility can serve as an alternative to standard equity portfolio hedges, such as put options. The ML US FEVR Index efficiently tracks volatility using a strategy designed to minimise the carry cost associated with owning volatility while attempting to capture many of the important benefits that a long volatility strategy provides.
Merrill Lynch Global Research has found that over the past two decades an allocation of 25% FEVR and 75% S&P 500 would have generated the highest returns per unit of risk. Such allocation leveraged to the same risk level as the S&P 500 would have outperformed a long-only equity investment.
“Given the high negative correlation to equities, considering volatility as an asset class and integrating it into a portfolio could help to significantly reduce overall portfolio risk. Moreover, volatility can provide equity investors with protection when they most need it, during periods when markets are declining sharply,” says Heiko Ebens, head of Equity Derivatives Research, Merrill Lynch.
In March 2007, Merrill Lynch Research first introduced the Forward Equity Variance Rolling (FEVR) concept and applied the strategy to the Dow Jones Euro STOXX 50 Index to access the volatility of equity markets within the Eurozone.
“The Euro FEVR strategy has proved its defensive nature during the subprime crisis when equity volatility spiked. Since March 2007, the weekly return correlation of the Euro FEVR strategy to the market has been -72%, highlighting the diversification benefits of an investment in volatility during periods of uncertainty for equity markets,” says said Alex Ypsilanti, head of European Equity Derivatives Research, Merrill Lynch.