Diversification and why the Ulcer Index Matters

Stuart Barton I June 21, 2017

Synopsis

At Invest In Vol we believe that alternative assets offer investors an important source of investment diversification, and that trading strategies harnessing Volatility Risk Premium can return high Sharpe Ratios and low correlation with the S&P 500.[1] In this article we explain the importance of implementing a diversified approach when investing in volatility, and how Invest In Vol offers clients the diversification required to help improve risk adjusted returns.

Why Diversification Matters

Harry Markowitz presented the advantages of investing in uncorrelated assets in 1954 by demonstrating how portfolios of less than perfectly correlated assets can exhibit better risk return characteristics than any individual assets on their own.[2] In our paper Volatility – An Investment Case, we introduced some of the benefits of volatility investing, discussed the concept of Volatility Risk Premium (VRP), and explained how an account with Invest In Vol can access and profit from this premium.

An important consideration when investing in volatility is the underlying volatility of its returns. While individual strategies can deliver positive returns in the long run, drawdowns in the short run could make an otherwise good long term investment unpalatable to some investors. Invest In Vol works to mitigate some of these drawdowns by diversifying volatility investments across a series of strategies constructed by a diverse group of strategists – effectively applying Markowitz’s diversification approach to volatility investment accounts.

Measuring Volatility, Risk and Performance

Markowitz’s work has come under considerable criticism over the years, particularly for using Standard Deviation as its primary measure of market risk. Standard Deviation is a statistical measure of deviation from a mean, and treats both positive and negative deviations equally. For example, an asset that moves up quickly could be considered to have a higher Standard Deviation – and therefore more risky – than one that falls slowly, despite the investors’ obvious preference for positive returns over drawdowns. It is for this reason that together with Standard Deviation and Sharpe Ratio, Invest In Vol uses an additional risk metric – the Ulcer Index (UI) – and an additional performance metric – the Ulcer Performance Index (UPI).

The Ulcer Index

Devised by Peter Martin in 1987, the Ulcer Index tries to improve on Standard Deviation as a measure of risk by only considering the volatility of an asset in the downward direction i.e. measuring the size of drawdowns over any given period. This innovative approach is more critical of assets with large drawdowns and benefits assets with high returns – an approach we find more in line with our investors’ objectives.

To calculate the Ulcer Index we first take the difference between the present price of an asset and its historical maximum, and divide this by its maximum price. This gives us the relative drawdown if negative, or zero if the asset is at its historically maximum price.

We then take the root mean square of these individual relative drawdowns to get the asset’s Ulcer Index.

As its name implies, investors want this Index to remain as small as possible, as a larger Ulcer Index is an indication of an asset with larger or more frequent drawdowns. Unlike Standard Deviation, the Ulcer Index is reduced by strong movements upward beyond the asset’s previous maximum price.

The Ulcer Performance Index

The Ulcer Performance Index uses the Ulcer Index in the same way that the Sharpe Ratio uses Standard Deviation, but, instead of including both up and down moves as its measure of risk, the UPI includes only drawdowns.

Like the Ulcer Index, Invest In Vol finds that the Ulcer Performance Index is far more aligned with our investors’ objectives.

Diversification, Drawdowns and the Ulcer Performance Index

Invest In Vol manages volatility investments to try and maximize their Ulcer Performance Index. That is to say that we strive to capture as much of the Volatility Risk Premium available, while trying to avoid large drawdowns. Invest In Vol strives to achieve this by offering a balanced strategy diversified across multiple volatility strategies. While one strategy may prove susceptible to overnight shocks, another strategy may not. This diversification offered by imperfectly correlated strategies can improve an investment’s Ulcer Performance Index.

How do I access diverse volatility returns?

Invest In Vol is an SEC Registered Investment Adviser (RIA) that offers clients a diverse set of volatility strategies from a group of leading volatility strategists in one managed account. By focusing exclusively on volatility as an asset, Invest In Vol works with investors and other advisors to raise awareness and understanding of volatility investing, and to deliver the returns of volatility as an asset.

Invest In Vol offers its strategies to individuals and other financial advisors though separately managed accounts (SMAs). Managed accounts are opened and funded by the investor, and Invest In Vol is given limited permission to trade on their behalf. Invest In Vol’s SMAs give investors access to the knowledge and experience of our professional traders and strategists while retaining full control over the ownership of their funds. Furthermore, in addition to retaining ownership and control, investors can track and manage their accounts anytime and from anywhere using their computer or smartphone, and can withdraw, close or add funds at any time.

Conclusion

An Invest In Vol SMA is an alternative asset that seeks to harvest the longer term risk premium exhibited in the equity volatility market. We are the first RIA to offer clients a diverse set of volatility strategies from a group of leading volatility strategists, offering investors the opportunity to diversify across multiple strategies in one account. In contrast to the hedge fund approach, SMAs allow investors to retain full ownership and control of their funds, as well as gain full transparency on trading and market value.

[1] Cooper, T. (2013) Easy Volatility Investing, Social Science Research Network. Pg 1. [2] Markowitz, H. (1952) Portfolio Selection, The Journal of Finance, Vol. 7, No. 1. (Mar., 1952), pgs. 77-91.

Disclosure

Investing involves risk, including the possible loss of principal. Carefully consider the Strategy’s investment objectives, risk factors, charges and expenses before investing. This Strategy is actively managed and there is no guarantee investments selected and strategies employed will achieve the intended results. Strategy is subject to change. Active management may also increase transaction costs. The Strategy is not diversified, and narrowly focused investments may be subject to higher risk.

Past performance does not guarantee future results. This information has been provided by Invest In Vol. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This is not to be construed as an o er to buy or sell any financial instruments and should not be relied upon as the sole factor in an investment-making decision. References to specific securities and their issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. The views and opinions expressed are those of the portfolio manager at the time of publication and are subject to change. There is no guarantee that these views will come to pass. As with all investments there are associated inherent risks. Please obtain and review all financial material carefully before investing. Investments are subject to change without notice.


For a more complete disclosure please visit www.investinvol.com/disclosure.

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Investing involves risk, including the possible loss of principal and fluctuation of value. Past performance is no guarantee of future results. Carefully consider the investment objectives, risk factors, charges and expenses before investing. Invest In Vol, LLC is the investment advisor for the separately managed accounts (SMAs) and advisory services; it provides investment advisory services to clients and does not sell securities. For a more complete disclosure click here. For a more complete description of our business, Form ADV 2A, and accompanying brochures, click here.

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