Diversification of investments is often heralded as the only free lunch in investment management and although it does have its merits, it is a rather crude tool, according to volatility manager Triple3 Partners.
"The whole idea about diversification is that you don't put all of your eggs into one basket, but as we saw in 2008, when a real crisis happened, correlations skyrocketed and that diversification benefit becomes maladroit," Triple3 executive director Simon Ho said.
"The case for diversification falls apart at the point when you need it most."
Instead, investors should make better use of options, but option strategies often suffered from having the reputation of being risky, while Ho also said they were not always used in the smartest way.
"Options are underutilised because of the associated negative risk. But options are the most efficient tool for reshaping your profit distribution and it just needs to be done properly," he said.
"My proposition is that the only way to properly insure one's portfolio [against volatility] is through options. You can guarantee that you won't lose beyond a certain point, while with diversification you can only give an estimate of what it might do for your portfolio."
Triple3 Partners was established two years ago by Ho and former Swedish Central Bank adviser and academic Dr Paolo Giordani.
They shared an interest in modelling volatility and created an algorithm that comes up with a portfolio of options that seeks to reduce volatility, based on an investor's preferences for risk tolerance, volatility and costs.
Backtesting of the method revealed that over the period 2000-10 volatility was reduced by almost 70 per cent under certain conditions, while investment returns were not compromised in the process.
The firm now offers volatility management services that include a volatility overlay and dynamic asset allocation services.
Ho has modelled his overlay on the commonly-used currency overlays to make the method more user-friendly.
However, the strategy can also deter from performance in booming markets.
"There is no free lunch. If the market strongly rallies, we will underperform," Ho said.
Ho is currently in discussions with three superannuation funds and one fund manager about the volatility overlay and said one of them would make a decision on it in June.
