• How do volatility funds work?

• Why invest in volatility?

• What are the risks of volatility funds?

• Who are volatility funds suitable for?

Typical volatility funds use the expected future fluctuation contained in option prices — the implied volatility — as the basis of their strategy. Implied volatility is the future volatility expected by the market, derived from option prices. Fund managers use this figure to develop specific volatility strategies, of which there are basically two broad categories:

• Volatility premium strategies (also known as short volatility strategies or volatility income strategies): These approaches aim to systematically collect a volatility premium - i.e. a risk premium for bearing market fluctuations. In practice, this is usually achieved by selling volatility, e.g. by writing options or entering into volatility swaps. The income results from the fact that the implied volatility on the markets tends to be higher than the volatility that is ultimately realized. The focus is on steady returns and premium income, not on hedging. Volatility premium strategies therefore generate ongoing income as long as the markets remain relatively calm, but can suffer losses if extreme fluctuations occur (more on this under risks). The key question for correct implementation is therefore how risk management is structured and whether hedging mechanisms are in place to cushion price falls.

• Long volatility strategies (diversification strategies, implemented e.g. in special long volatility funds): These approaches pursue the opposite - they buy volatility in order to profit from a sharp rise in volatility. Market volatility typically rises in phases of sharply falling equity markets, which is why long volatility strategies can be valuable as a diversification tool. They generate large gains in crash phases and thus act as a counterweight in the portfolio: Losses in risky investments (e.g. equities) are partially or fully offset as the volatility fund gains significantly in value over the same period. In contrast to the income variant, the focus here is not on continuous income, but on diversification and the stabilization of investment portfolios.

Other distinguishing features: A key difference between various volatility strategies lies in their objective - do you primarily want to generate current income or stabilize the portfolio through a long volatility strategy? The volatility markets on which the fund focuses also play a role: Some strategies focus exclusively on the volatility of large equity indices, while others also utilize single stock volatility. The latter requires even more extensive data and expertise, but opens up additional sources of returns and further scope for diversification (fluctuations in individual stocks can be different to those of the market as a whole). Regardless of the approach, volatility funds work with derivative instruments and active risk management in order to achieve their respective objectives - income or diversification.

Volatility as an asset class offers two particular benefits for investors: Additional sources of income and diversification. Depending on the strategy, the focus is sometimes on one and sometimes on the other — but ideally a volatility allocation can achieve both benefits in the portfolio context.

Additional returns through the volatility premium: A systematic volatility risk premium has been observed in the capital markets for decades. On a long-term average, the implied volatility (expected fluctuation) on equity markets, for example, is significantly higher than the volatility realized later — in other words, more fluctuation is expected than actually occurs. In the long term, the implied volatility of the S&P 500® is around 20 percent, while the actual fluctuation in hindsight only reaches around 17 percent.¹ The difference of a good 3 percentage points, also known as the volatility premium, represents a source of income that a short volatility fund can specifically capture. Over long periods of time, this implied-vs-realized spread has proven to be quite stable — in other words, selling volatility (e.g. through option premiums) can open up an attractive source of returns in the long term. However, "collecting premiums" is not a risk-free game: In extreme market phases, the relationship can also be reversed, i.e. the realized volatility temporarily exceeds the implied volatility. In such times of stress, unprotected short volatility positions suffer losses — an aspect that must always be taken into account in risk management. Many premium approaches therefore also use hedging positions that cost less premium than is collected. E.G:

• Buying single stock volatility— the volatility premium is typically less pronounced here than with indices. Strategies that buy single stock volatility and sell index volatility are called dispersion strategies.
• Out-of-the-money put options— These options generate profits in the event of very strong market dislocations.
• VIX futures— Futures on the VIX volatility index can enable short-term profits in the event of price distortions.

Diversification and crisis protection: The second major advantage of a volatility investment is its diversification potential. Long volatility strategies develop their greatest benefit precisely when conventional investments weaken — namely in phases of sudden market panic and price slumps. If volatility rises sharply (for example in a stock market crash), long volatility funds often achieve extreme gains and can thus cushion losses in equities or other risk positions. The first quarter of 2020 provided an impressive example: While the stock markets collapsed during the COVID crash, the Assenagon Long Volatility strategy recorded an increase in value of around +40% in just a few weeks. Such results show how anti-cyclical and protective volatility building blocks can be. In the overall portfolio, a small allocation to volatility can thus improve the risk-adjusted returns — i.e. increase the return relative to the overall risk taken. In short, a long volatility investment acts as a reliable source of diversification that also helps when conventional diversification strategies consisting of equities and bonds fail.

Despite their opportunities, the special risks of volatility funds should not be overlooked. The strategies are complex and can lead to considerable losses if handled incorrectly. Essentially, the risks reflect the two opposing approaches:

• Short volatility strategy risks: Those who sell volatility and collect the volatility premium generate steady returns during calm periods, but incur the obligation to pay up in the event of extreme swings. Sudden jumps in volatility - caused by a market crash or unforeseen shocks, for example - can inflict heavy losses on short volatility positions. A historical example is the volatility shock in February 2018 ("Volmageddon"), which caused several products based on volatility selling to implode in one fell swoop. In such scenarios, the premium earned up to that point abruptly turns negative. Although the volatility premium remains statistically positive over the long term, investors must be able to withstand tail risks (rare extreme events). Risk management and position sizes are crucial here - reputable volatility funds limit their leverage and use mechanisms such as targeted hedging strategies to avoid excessive drawdowns.

• Risks of the long volatility strategy: Buying volatility (i.e. betting on rising volatility) has the opposite profile. Although long volatility funds gain strongly in times of crisis, they incur ongoing costs in normal market phases. As volatility tends to remain low or fall in calm markets, traditional long volatility positions lose value - you can compare it to an insurance premium that is paid regularly. This negative return in sideways phases requires staying power: Investors must be prepared to accept ongoing small losses in order to receive the big payout in a crash. If such a strategy is abandoned too early, the protective effect may be missed just when it is needed. The key is how the long volatility strategy is implemented in order to find the right balance between a high return during periods of stress and the carry (i.e. the profit/loss) when holding the position. Simply buying index volatility can lead to a high carry burden in the long term, as the premium that short volatility funds earn is paid in. The use of single stock volatility, for example, can help here - here the volatility premium is significantly lower and thus offers the opportunity for a much more stable medium-term performance - even if nothing happens on the market. A popular strategy consists of buying individual share volatility (low premium), which is financed by selling index volatility (high premium) (so-called dispersion strategies).

• Complexity and operational risks: Market risks aside, volatility funds are sophisticated products in themselves. They use derivatives that are associated with counterparty risks, liquidity risks and model-based valuation risks. It is often difficult for private investors to understand how they work, which can give rise to false expectations. In addition, volatility strategies are comparatively data- and model-intensive - a mistake in strategy or risk management can have expensive consequences. Investors should therefore rely on experienced managers who have a proven track record in this specialist area. Overall, it is important to note that volatility funds are not a "sure-fire success". The particular risks must be understood and actively managed so that the intended benefits (additional return or diversification) actually materialize.

Due to their special characteristics, volatility funds are primarily aimed at professional investors and institutions that want to strategically optimize or diversify their portfolio. Both target groups can make good use of volatility strategies - albeit in different ways:

Strategically oriented investors (e.g. asset managers, pension funds, long-term private portfolio investors) are increasingly viewing volatility as a permanent portfolio component. Whereas volatility used to be almost exclusively a field for short-term bets, there are now also uncorrelated volatility strategies with a long-term investment horizon. Institutional investors are now specifically integrating volatility funds into their strategic asset allocation in order to stabilize overall returns and tap into additional sources of income. Structured approaches are particularly suitable for them: For example, a volatility premium strategy can serve as a steady income component in the portfolio - similar to an alternative to bonds or credit strategies, with moderate risk and a regular premium. At the same time, a long volatility strategy can be held as a diversification component to hedge the portfolio against extreme losses. Some long-term concepts (e.g. so-called "all-weather" portfolios) even combine both approaches: A core income strategy flanked by a long volatility component as protection. The advantage for strategic investors is that well-balanced volatility funds often have a low correlation to traditional investments such as equities and bonds - they can therefore improve diversification. However, long-term investors must also have the patience and discipline to hold such positions over market cycles. This is because the added value sometimes only becomes apparent in times of crisis or over several years. Overall, volatility funds are suitable for investors who either want to actively focus on volatility opportunities or who want to make their portfolio more robust - provided they have a sufficient understanding of this complex asset class. In many cases, access via specialist fund managers who have the necessary infrastructure and experience to implement volatility strategies professionally is recommended. .

Volatility funds can actually do both - deliver additional returns and make the portfolio more resilient, provided they are used correctly. The question posed at the beginning can therefore be answered in the affirmative: Yes, investors can use volatility funds to benefit from market fluctuations and reduce their risk at the same time. How this effect is achieved depends on the strategy: The volatility premium strategy generates a steady stream of income from the risk premium, while the long volatility strategy acts as a protective shield in crises and mitigates losses. Ideally, a volatility investment complements the rest of the portfolio by either generating current income or acting as a buffer during periods of stress. However, it is important to emphasize that volatility funds are not a free ride - they require expertise, active management and a clear understanding of the risks. For suitable investors, they nevertheless represent a strategically sensible portfolio component for both tactically targeting market inefficiencies and strategically increasing diversification. Volatility funds can turn volatility from an enemy into an ally - and turn many a stormy stock market phase into an advantage.