The usual advice for managing investment portfolios is to take a holistic approach and consider a client’s holdings as an integrated whole. But that approach wasn’t always optimal when evaluating equity allocations in variable annuities (VAs) with generous guaranteed benefits. In those cases it often made sense to override the full-portfolio target allocation and increase the equity exposure to take advantage of the VA’s contractual guarantees.

That approach can backfire on two levels, however. While VA owners doubtless appreciate the increased equity exposure during bull markets, the reduced diversification could rattle them and cause them to switch out of equities when stocks’ volatility increases, particularly in a bear market. High equity exposure, combined with historically low interest rates, has strained VA issuers in recent years, as well. They can raise contract fees and reduce benefits to an extent, but a competitive market limits just how far they can go.

A better method?

A possible solution that’s been gaining momentum is to manage investment portfolio volatility, which could benefit both investors and insurers. According to research firm Strategic Insights, assets in managed volatility accounts rose from “$35.3 billion at the end of 2006 to $305.8 billion at the end of 2013, an annualized growth rate of 36.1 percent.” Assets reached $360.9 billion by the end of 2014’s second quarter; VA assets comprised 72 percent of that amount.

A sub-account or fund can choose from several methods to control portfolio volatility. It can target a level of volatility and dynamically adjust equity weightings in response to market conditions. Another approach is to cap volatility and a third is to focus on principal protection. Additionally, there is a range of strategies used within each category.

Eric Henderson, senior vice president for annuities and life insurance with Nationwide in Columbus, Ohio points out that higher volatility is often, but not always, correlated with down markets. His firm uses that general historical result in its efforts to maintain a certain level of volatility in its managed volatility VAs. “What typically happens is as the volatility of the equity markets goes up, you try to change the nature of the funds so that the volatility of the entire fund stays within some range,” he says. “And that can be done by changing your allocation between equities and bonds. It can be done by doing some futures or other types of hedging type of activity within the fund but the goal of the fund is to keep volatility in sort of a range or managed in some manner.”

Will it work?

Managing volatility sounds like a good approach, but most of the portfolios trying it haven’t experienced prolonged market declines so it’s difficult to evaluate the strategies’ long-term effectiveness. Writing in Investment News in late November, Thomas Hoop with Legg Mason reported that the managed volatility strategies performed well during the high volatility market from Oct. 8 to 16. Among the funds he studied: “While the S&P 500 declined 3.68 percent, 88 percent of the publicly available U.S. managed volatility funds beat the benchmark; the median excess return was 1.40 percent.” The funds did well during the market’s overall positive result for the full month, as well, he notes.

Hoop’s research focused on funds but the results should apply to VA sub-accounts that use the same strategies. It’s an encouraging result that also serves as a reminder for VA-owners that managing volatility is not the same as eliminating it. It’s relative protection, not absolute. When the equity markets drop, most managed volatility strategies will still experience losses but they should be smaller than the applicable market benchmarks. There’s likely to be a upside trade-off with some degree of benchmark underperformance, as well.

Managed volatility VAs can benefit both investors and insurers, says Henderson. He notes that the contracts’ living benefits were “a lot richer” before the financial crisis and the significant decline in interest rates. Managed volatility products can allow insurers to provide richer benefits again. “One way to offer a richer living benefit is through the use of managed vol(atility) funds,” he says. “It’s a way to say I’ve got my normal living benefit design and the hedging that goes along with that. If I can offer some managed volatility, that allows me to offer some greater benefit to the client.”