Risk Control: Who Cares?

Published date01 January 2017
Date01 January 2017
Risk Control: Who Cares?
Nick Taylor
University of Bristol, School of Economics, Finance and Management, University of Bristol, Bristol,
E-mail: nick.taylor@bristol.ac.uk
The performance of recently introduced risk-control indices is evaluated and
tested with respect to a set of competing indices. Applying a method of moments
methodology to these data reveals that the performance of strategies that track
risk-control indices have economic and statistical signicance to investors with
realistic risk aversion parameter values. However, this performance varies over
time and appears to be determined by macroeconomic and liquidity conditions.
Keywords: risk control, volatility, certainty equivalent return, method of moments
JEL classification: G53, G11, G17
1. Introduction
Financial crises remind investors of the perils of excessive risk-taking behaviour. It is not
surprising, therefore, that the post-2007 period has seen considerable growth in products
that seek to highlight the virtues of limited risk exposure. One such example is the
introduction of risk-control (RC) indices; e.g., the S&P Dow Jones family of RC
Such series are based on a time-varying weighted average of a (high return/high
risk) equity and (low return/low risk) cash index, with the weights determined by the
expected level of equity return volatility. During periods of high expected volatility, a
low equity weight is used in order to limit exposure to the risky equity market. By
contrast, low expected volatility levels coincide with a high equity weight. It is the
desirability of strategies based on tracking these RC indices (henceforth cash/equity
(RC) strategies) that we examine in the current paper.
RC indices have received considerable attention in the popular nancial press. For
instance, the Buttonwood article in the Economist magazine (November 1st to 7th,
2014, p. 80) highlights the virtues of these indices (and the tracking thereof)
to pension fund managers who require high returns in order to pay the pledged
benets. As cash pays small returns, these managers invest in equity with higher
The author thanks two anonymous referees and participants in the departmental finance
seminar at Bangor University for helpful comments. Correspondence: Nick Taylor.
Other providers tend to use similar names for their RC series. For instance, Russell
Investments use the title: Russell Volatility Control Index Series.
European Financial Management, Vol. 23, No. 1, 2017, 153179
doi: 10.1111/eufm.12094
© 2016 John Wiley & Sons, Ltd.
However, this leaves them exposed to bear markets such as those observed
in 2001/02 and 2008/09. Therefore, for such managers the holygrailwouldbea
combination of equity-like returns with reduced volatility(Economist, 2014). As
cash/equity (RC) strategies may full this need, their performance is the subject of
the current paper.
The cash/equity (RC) strategies studied in the current paper are examples of a
wider class of strategies referred to as dynamic strategies. Such strategies are
characterised by time-varying positions in assets such that the utility of investors is
maximised. Expectations of the moments associated with the returns to the assets
are key inputs within this context. Early approaches focus on the rst moment
(market timing strategies); see, e.g., Ferson and Harvey (1993), Kandel and
Stambaugh (1996) and Pesaran and Timmermann (1995). More recently, the focus
has shifted to higher moments.
In particular, volatility timing strategies are
demonstrated to have considerable economic value; see, e.g., Chiriac and Voev
(2011), Fleming et al. (2001, 2003), Marquering and Verbeek (2004), Taylor (2014)
and West et al. (1993).
Given this success, market practitioners have introduced
their own simplied versions of volatility timing strategies, such as cash/equity
(RC) strategies. It therefore seems sensible to assess whether these particular
strategies also have economic value. This represents the rst contribution of the
The second contribution concerns the method used to assess the economic value of the
cash/equity (RC) strategies. A number of approaches have been used to assess the
economic value of trading strategies within an asset allocation setting. We build on
perhaps the most commonly used measure of economic value, the certainty equivalent
return (CER); see Campbell and Thompson (2008), Cenesizoglu and Timmermann
(2012) and Welch and Goyal (2008) for recent applications. Unlike previous applications
of this technique, we estimate the CER within a method of moments (MM) framework.
There are two benets to using the proposed framework. First, it is possible to estimate
the differences in CER values across competing strategies within a single estimation
procedure. Second, we are able to apply a conventional MM-based statistical test of the
signicance of the CER.
The MM-based CER framework is essentially a collection of pairwise comparisons,
with the difference in CER values constructed for a particular strategy with respect to a
competing strategy. In our case the strategies are: cash only, equity only and a cash/
equity strategy with a time-varying wealth allocation, namely the cash/equity (RC)
strategy. The latter strategy differentiates itself by delivering a broadly constant
conditional volatility. Given that a number of different strategies are considered, it is
Cash is typically represented by a money market instrument.
This switch reects the widely accepted view that accurate forecasts of expected returns are
particularly difcult to obtain (Merton, 1980).
See Cenesizoglu and Timmermann (2008) and Jondeau and Rockinger (2012) for empirical
evidence regarding the economic value of forecasting the return distribution within an asset
allocation setting.
The CER is dened as the guaranteed return that an investor would accept to be indifferent
to taking on a risky strategy.
© 2016 John Wiley & Sons, Ltd.
154 Nick Taylor

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