# In portfolio theory, has volatility a logical place as an asset class?

Some years ago, a colleague made the argument that volatility should be thought of as an asset class. That means that taking exposure to implied volatility, in the form of volatility bonds, or long dated OTC options, can enhance returns and have low correlation to existing traditional portfolios. This was said in the context of interest rate volatility, although the same could be said of fx or equity volatility. Does anyone agree or disagree with this concept? Is volatility an asset class?

I accept that volatility is a risk factor, not an asset class, as @kiwiakos points out. Suppose someone suggests a volatility bond, where you receive the realized volatility on some underlying asset over some period. Does this ever have a logical place in a portfolio?

• @AK88, i consider Hedge Funds to be a compensation scheme not an asset class – dm63 Dec 28 '16 at 13:36

IMO: Volatility is a risk factor not an asset class. Asset classes are collections of assets and volatility is not one. Options, volatility derivatives, etc, are asset classes which might offer exposure to volatility. You wouldn't say that 'the stock return is an asset class' but rather 'stocks constitute an asset class'. Of course some would define the 'volatility asset class' as the class that pretty much includes all derivatives. Nothing wrong with that, it is a matter of definition.

Now whether or not volatility as a risk factor has low correlation with other risk factors is another question. IMO it is not a low correlation asset especially during market turbulence. Stocks and their volatility jump together, even if they exhibit low correlation during normal times. Exchange rates are the same. Interest rate volatility correlates with the slope of the yield curve, which in turn follows the business cycle. Etc.

Also to take on volatility risk one typically needs to also take non-linear exposure to other factors, liquidity risk, tail risk, etc. Volatility can be used to hedge effectively, but it is not for everyone and correlation is not a sufficient metric of dependence.

• What I wanted to say but better. – Bob Jansen Dec 27 '16 at 17:46
• Do you consider Hedge Funds an asset class? – AK88 Dec 28 '16 at 4:20

Whether volatility is an asset class or not is a matter of point of view. Nevertheless, funds exist to have exposure to it such, for example ETFs (see here, to name a few).

Adding such a fund to a multi-asset portfolio is perfectly fine for example. You would expect its return to be decorrelated (i.e. $\rho << 0$) from the underlying asset class (for example Equities for VIX) in a bear market at least. Probably quite uncorrelated (i.e. $\rho 0$) to it otherwise although I have not personally tested this.

It is particularly useful for long-only funds where as it gives you a long exposure on the downside.

I agree with Kiwiakos though that if you're doing factor-based risk allocation you would probably find it to be correlated to the other factors which is obviously an issue.

Finally that this is an exposure to implied-volatility though, not really observed volatility. So if market severly overprice or underprice risk in the markets (puts or calls very expensive, for example) you might be able to catch some other kind of "risk" there if you're not allowed to hold derivatives in your portfolio.

I agree with @SRKX that it is a matter of perspectives. I have seen various types of classifications of asset classes. For example:

• at CPPIB they believe there are only 2 asset classes - stocks and bonds;
• JPMAM has three asset classes - Equities, Bonds, Alternatives (including HF, PE, VC, Real Estate, Commodities, Gold);
• GSAM is more granular and has like 20 asset classes (at least it was presented so by their GPS team). They strongly believe that HF and PE should be treated as seperate asset classes, as they have unique risk return characteristics;
• Antti Ilmanen also treats HF, PE, VC as different asset classes in his book. He then talks little about volatility being an asset class, but does not state it explicitly;
• Andrew Ang argues that HF and PE are not asset classes;
• list goes on and on.

I have not seen clear definition of asset classes, but according to this document:

How do we define an asset class? There are several ways to do so. The first is in terms of the investment attributes that the members of an asset class have in common. These investment characteristics include (1) the major economic factors that influence the value of the asset class and, as a result, correlate highly with the returns of each member included in the asset class; (2) have a similar risk and return characteristic; and (3) have a common legal or regulatory structure. Based on this way of defining an asset class, the correlation between the returns of different asset classes would be low.

Now, can we treat volatility as an asset class? There have been some discussion regarding this issue (here, here, here, etc.). Based on this, I think volatility could be treated as an asset class. It has been around for a while and unlike strategies like value, momentum, size, volatility actually has a commonly traded product - VIX.