It had been a fairly quiet year for the U.S. equity market volatility until mid- to late July. 

The Dow Jones industrial average was around 18,000 at that time and the CBOE Volatility Index — the VIX — was below 15.

Market sentiment soured soon afterward, though. 

By Aug. 21, the Dow dropped to the 16,600 range and entered correction territory while the VIX had spiked to over 25. Some market pundits were declaring that the bull market was nearing an end and investors should brace themselves for significant movement lower. 

Should that happen, it will be interesting to see how managed volatility variable annuities (MVVAs) hold up. The motivation for MVVAs is clear from the issuing insurers’ perspective. Highly volatile markets make it more difficult to price VAs’ living benefits correctly. 

If an issuer can manage an underlying portfolio’s volatility effectively, it’s easier to hedge against risk and estimate a portfolio’s range of returns.

From the investors’ perspective, managed volatility can help reduce the impact of equity market downturns — the so-called “tail risk” — which in turn can reduce the urge to sell stocks at precisely the wrong time. 

Numerous VA-issuers use the managed volatility strategy. According to research firm Strategic Insights, MVVAs held about 75 percent of the $361 billion of managed volatility assets at the end of 2014’s second quarter. 

See also: Will managed volatility keep VA owners on track?

Steve McDonnell, president of Soleares Research LLC in Astoria, New York and publisher of The Soleares Report, which monitors the VA market, says there were 203 MVVA portfolios operating at the end of this year’s first quarter. The growth in MVVA assets appears to be leveling off, which isn’t surprising, he notes, considering that most insurers that planned to offer the products have done so.

One market trend that he has noticed is that some insurers are adding managed volatility to existing portfolios that previously did not have the feature. Tamiko Toland, managing director for retirement income consulting with Strategic Insight in New York City, also cites a reduced number of new MVVAs coming to market. 

“We have seen continued increase in the number of funds that are available and registered,” she says. “That activity has started to tail off, though, so we’re not seeing as many new registrations. It really dropped off quite a bit in 2014. Which isn’t to say that we don’t see new funds — it’s just we’re not seeing them at the same rate.”

Evaluating the strategy

MVVAs can adopt a range of strategies to achieve their goal of reduced tail risk. In general, says Toland, most funds use derivative overlays because they require fewer assets and can be implemented quickly. 

“If you are using an allocation strategy and you have a market event that requires a reallocation, then it’s a fairly large number of trades that goes in multiple directions, and there’s a lot of friction associated with that, meaning transaction costs,” she explains. 

“So it can get a little bit expensive to do it that way, but then again, you’re not using derivatives, so some companies are comfortable with that and you can use a blended strategy as well, which certainly happens. But I would say that for the funds that are used specifically to mitigate the risk of benefits, the predominant strategy is to implement derivatives to a large extent.”

MVVAs lack long-term performance records and haven’t experienced an entire market cycle, Toland notes. In addition, their methodologies for managing volatility are proprietary, and those two conditions makes it difficult to evaluate a strategy’s short- and long-term effectiveness. 

Ultimately, advisors need to monitor the accounts’ performances and total returns, McDonnell cautions. In particular, given the equity markets’ relative calm since early 2013, advisors should monitor how MVVAs perform if the mid-August pullback turns into a full-blown bear market.