Gray Matters
The Price of Managing Volatility
By Rajneesh Motay
Do riders with volatility controls cost VA investors
potential gains?
Insurers are increasingly limiting investment
options in their variable annuities that
have riders to strategies with built-in volatility
management. Volatility overlays mitigate
the risks for insurance companies by embedding some hedging within the investment
strategy. But are investors who buy the riders
giving up a portion of potential gains in
return? We investigate this question by
comparing two contracts with similar benefits;
one with a volatility control overlay and one
without an overlay.
Targeting Risk
Most asset-allocation offerings use the
percentage of stocks to serve as a proxy for
risk. These are commonly billed as “target-risk
funds.” A “conservative” target-risk fund
typically holds between 20% and 50% of its
assets in stocks; moderate, moderategrowth, and growth options are analogously
defined as portfolios with increasing amounts
of equity exposure. This approach to investment-risk classification is reasonable because
a portfolio gets more volatile as the percentage
of stocks it holds increases. But risk here is
understood in relative terms. Where this
classification system falls short is in ignoring
the absolute level of volatility. Exhibit 1 charts
the rolling 30-day standard deviation of a
“moderate” target-risk portfolio. It shows that
the realized volatility was far from “moderate”
during the difficult markets of 2008–2009,
when standard deviation reached a high of
40%, a level of volatility that would have been
unexpected even from an aggressive portfolio.
That experience was an unpleasant surprise to
most investors, and it drove many investment
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Table of Contents for the Digital Edition of Morningstar Advisor - June/July 2013