A category of investment indexes is enabling agile adjustments across a combination of assets – like cash or bonds on the low-risk side, and stocks on the high-risk side – in a single fund, typically an annuity.
With these volatility control indexes, also known as risk control indexes, investors decide how much volatility they are comfortable with. Once the target is set, stocks are sold and bonds are bought when the equity market becomes too volatile for comfort. The reverse occurs when the stock market calms down.
This contrasts with a conventional balanced portfolio approach in which investors may allocate 60% to stocks and 40% to bonds.
Volatility control indexes tap into the lack of correlation between volatility and equity returns.
“A high-volatility regime can be used as a potential signal to rebalance and de-risk your holdings, and vice versa,” explains Arsen Arutyunov, vice president, sales at quantitative analytics and technology provider Numerix.
These indexes are said to virtually eliminate a host of investment and regulatory risks. But there are also potential pitfalls, ranging from mistiming the market to contagion caused by crowded trades.
Insurance companies started using volatility control indexes after the 2008 financial crisis as risk-averse investors turned to fixed index annuities (FIAs), which guarantee a rate of return and principal protection. These helped insurers control spending on the put options they use to keep annuity performance on track.
Reggie Xu of Milliman
The “most popular” index volatility target, measured as the potential decline in a publicly listed stock’s value, was 5% until recently, says Reggie Xu, a trader and risk manager at risk solutions company Milliman. “We’re now seeing volatility targets of 10%, 15% or even 20%.”
This change is driven by higher interest rates, which have raised the yields on investments in insurance companies’ general accounts. For investors, the result is participation rates – their share of the performance of an index – rising as high as 200%, according to Xu.
“Higher volatility increases the cost of options but also provides a greater probability of achieving better returns,” Xu adds.
Index providers including Intercontinental Exchange, MSCI, Nasdaq and S&P Dow Jones Indices have started enhancing their volatility control indexes by using intraday data from securities trading to predict market volatility more accurately than by using end-of-day data. This innovation “largely mitigates the gap risk” of a sudden change in prices overnight, says Xu.
Salt Financial, which provides technology that powers the use of intraday data in these indexes, has partnered with, among others, UBS. The UBS truVol US Target Sectors Index went live in March 2021.
On January 16, 2025, UBS made public a collaboration with Nobel laureate Robert Engle on “a novel forward-looking intraday volatility forecasting methodology.” Engle, professor emeritus of finance, New York University, and co-director of the Volatility and Risk Institute, contributed a variation of the ARCH model.
Mathieu Pellerin, Dimensional Fund Advisors
“Volatility control methodologies have, for the longest time, been overlooked from an innovation standpoint, and we take the view that a good volatility forecasting method can lead to enhanced performance,” Ghali El-Boukfaoui, head of insurance sales at UBS Investment Bank, said in the announcement.
Mathieu Pellerin, retirement research director and vice president, Dimensional Fund Advisors, cites a hypothetical index with a mix of cash and equities with a target of 10% volatility annualized.
“A simple forecast, like the volatility based on daily returns over the past month, reduces the variation of rolling one-month volatility, or the ‘wiggles’ around the target, by half,” Pellerin says. “But if you move the target to a better forecast like intraday data, then it’s more like a two-thirds reduction.”
Using volatility control indexes in annuities reduces regulatory risk by lowering capital requirements on risk-weighted assets. “If the volatility control were not in place, the regulatory capital on these baskets would be quite substantial,” says Christian Kahl, Numerix’s chief customer officer.
“The key [new] risk is that the volatility overlays cause you to be caught off guard when there’s a sharp change in volatility,” says Dimensional’s Pellerin. “The forecast ability is based on the fact that most of the time, volatility is going to move slowly. If it’s been high today, it's going to be high tomorrow – maybe not as high, maybe a little bit higher – but it's going to be in that ballpark.”
Then there’s the risk of missing an upturn in market prices after a lull. “The risk is that when you reduce equity exposure, returns may end up being high right after you de-risk, and vice versa,” Pellerin points out. “The correlation between volatility and future returns is weak in our data.”
Model risk comes into play: “A lot of these volatility control structures are often presented through the lens of a historic back test,” says Arutyunov, noting that they “may indeed fail to perform as expected.”
While some indexes “are designed with clear and accessible methodologies,” says Milliman’s Xu, “some index methodologies can feel like a black box. Buyers don’t really know the mechanism behind them.”
Reputational risk can come from being accused of misrepresenting a complicated strategy to investors, says Arutyunov. “If it underperforms relative to the expectation set, you have to deal with potential repercussions.”
Too many institutions using similar algorithms could trigger contagion. Xu mentions a December 2018 episode “when the realized volatility spiked, most of the vol-control strategies needed to cut their exposure to get to their volatility targets,” and an equity market selloff accelerated.
Interest in annuities using these indexes is nonetheless growing among investors “ranging from mass affluent to very high net worth,” Pellerin observes.
Such interest led S&P Dow Jones Indices to launch S&P Managed Risk 2.0 Indices in 2020 in collaboration with Milliman.
“Increasingly, we are having conversations about risk control indices, especially as we continue to refine our lineup” as new 2.0 indices continue to roll out, says Sara Pollock, director of multi-asset indices at S&P Dow Jones Indices. “So the appetite is definitely there.”
Salt Financial has licensed its truVol Risk Control Engine to 23 institutions including Citigroup, Franklin Templeton, Invesco and Goldman Sachs in the last five years. In 2022, Dimensional used truVol in its Dimensional US Foundations Index, which Corebridge uses in its Power Series of Index Annuities.
Salt president and co-founder Alfred Eskandar estimates that $5 billion is now managed in FIAs that use truVol. “As markets evolve,” he says, “they become faster, and there is more data available – and not to use that data is leaving performance and accuracy on the table.”
According to Dimensional’s Pellerin, to meet their volatility targets, volatility control indexes are leveraged on the derivatives market, where securities are borrowed for options trades.
The Dimensional US Foundations Index invests in four indexes, the combined leverage of which was 82.44% as of December 31, 2024: Dimensional US Core Equity XM Index (ticker DFAUCXMT) at 25.73%, 10Y US Treasury Note Rolling Future Index (ENHAUSTT) 20.54%, 2Y US Treasury Note Rolling Future Index (ENHAUSTW) 20.54%, and Dimensional Enhanced Commodity Long-Short Excess Return Index (BHCVDXAT) 15.63%.
Since going live on September 30, 2022, the index has delivered an annualized return of 3.15% while tracking a volatility target of 5%.