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Understanding Volatility Risk

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A volatility risk rating gives an idea of how vulnerable a portfolio is to systematic risk i.e. the risk inherent to the entire market or market segment. By using StratiFi, advisors can understand ​how the portfolio may be expected to behave as downside market volatility increases. This risk is perhaps the most direct indicator of systematic risk to the markets as it is often accompanied by an increase in market swings. For example, you can expect portfolios with high exposure to volatility risk to experience losses in periods like Q4 of 2018.

In other words, this is the go-to factor to look at when markets are turbulent. StratiFi advisors utilize this factor to identify clients with portfolios that may experience short-term losses to proactively reach out to them to ease their minds.

While clients may believe that they own a “diversified” portfolio, each of the underlying assets in their portfolio is either negatively or positively correlated to market volatility. To calculate the volatility risk rating, we measure each asset’s exposure to volatility risk using a well-known measure of the market’s volatility (VIX Index) and separate assets with positive correlation (long volatility) to market volatility from those with a negative correlation (short volatility). This gives us a distribution of the said exposures.

Since we are considering risk, we are interested in extreme periods and this is why we extract the extremums of the distributions. Instead of picking min/max that may be too sensitive to fluctuations, we take the 1% percentile (99% percentile for positive betas). All those exposures are further market-value-weighted to compute the Ratio Long/Short volatilities and normalized to calculate the ratings from one to 10.

A portfolio will exhibit: – a low (good) rating if it is neutral to volatility or has, at least partially, long exposure to volatility – a high (bad) rating if it is extremely short on volatility or, more rarely, purely long (which would make the portfolio totally undiversified on the “volatility asset class”) – an average rating if its exposure to the volatility asset class is balanced.

Our PRISM™ risk analysis software uses a blend of risk tolerance questionnaires, historical market events, and current market signals to provide advisors with all the data they need to know their customers and plan accordingly. Contact us to find out how StratiFi can help your practice.

Akhil Lodha
Akhil Lodha Author
Co-founder & CEO StratiFi Technologies

Building the industry standard for understanding portfolio risk through cutting- edge technology at Stratifi.

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