Introduction
Volatility-controlled indices (VCIs), also known as risk control indices, are commonly used as index account options within index-linked annuities. The goal of the indices is to provide exposure to an underlying equity asset or multi-asset combination while realizing a volatility level close to a target.
How Does a VCI Seek to Achieve a Target Volatility Level?
The first thing about VCIs that comes to mind, for most, is the usage of the theoretical cash component in high volatility environments—but that is only half the story. On the flip side, how is the index designed to operate in periods of low volatility?
To answer that, we will review the two basic concepts that these indices employ, and when.
Market Volatility > Index Target Volatility
As indicated above, a VCI typically consists of an equity component and theoretical cash component or is an index of indices. When market volatility spikes, a VCI will allocate (or, in the context of indices, weight index components) away from the underlying index component and toward a risk dampening asset class, commonly a theoretical cash component. S&P DJI’s risk control index offerings include a variety of frameworks that use a theoretical cash component or a liquid bond index.
In this case, the VCI will allocate less than 100% to the underlying index, and therefore will not be leveraged. Allocation in a VCI refers to the weight attributed to each asset class, most commonly an equity component and a theoretical cash component.
The lower volatility asset class dampens the overall VCI’s volatility level, allowing the index to more closely realize a target volatility when market volatility is high.
Market Volatility < Index Target Volatility
On the other hand, when market volatility is below the target, the VCI can allocate more than 100% to the underlying equity or multi-asset index in an effort to increase volatility. A weighting of more than 100% to an underlying index component is referred to as leverage.
Leverage allows a VCI to increase volatility and more closely realize the target when market volatility is low.
Applying Leverage: An Example
To illustrate how leverage within a VCI could affect index performance, we will use the S&P 500® Dynamic Intraday TCA Index as an example. Please note that this outcome is not guaranteed but is included for general illustrative purposes only.
If general equity volatility is low, for the S&P 500 Dynamic Intraday TCA Index to more closely achieve its volatility target of 15%, it can allocate up to a maximum of 250% to the underlying S&P 500. This maximum is called the leverage cap.
If the S&P 500 posts results of 1%, at the leverage cap and under normal market conditions, the S&P 500 Dynamic Intraday TCA Index performance could be 2.5 times this, or 2.5%.
