Risk Control: Who Cares?

• Published date: 01 January 2017
• DOI: http://doi.org/10.1111/eufm.12094
• Date: 01 January 2017
• Author: Nick Taylor

Risk Control: Who Cares?

Nick Taylor

University of Bristol, School of Economics, Finance and Management, University of Bristol, Bristol,

BS8 1TU, UK

E-mail: nick.taylor@bristol.ac.uk

Abstract

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 significance 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

indices.

1

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 financial 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

benefits. 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.

1

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, 153–179

doi: 10.1111/eufm.12094

© 2016 John Wiley & Sons, Ltd.

returns.

2

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 fulfil 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 first 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.

3

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).

4

Given this success, market practitioners have introduced

their own simplified 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 first contribution of the

paper.

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.

5

There are two benefits 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

significance 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

2

Cash is typically represented by a money market instrument.

3

This switch reflects the widely accepted view that accurate forecasts of expected returns are

particularly difficult to obtain (Merton, 1980).

4

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.

5

The CER is defined 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