Editorial: Volatility and complexity

Richard Jory, Structured Products editor

In one part of the world, volatility would appear to be too tricky a concept to be sold to retail investors, though it may prove palatable to those that are more sophisticated. In the US, volatility is bandied about as a new asset class, while in Asia efforts to sell it in the form of either products or indexes have proved relatively fruitless.

For those in the know, volatility is becoming familiar and should probably make up at least some part of an investment portfolio. For those that have a simple outlook on investing, and who perhaps lack highly motivated financial advisers to guide us with skill, it might be best to stay away.

But it won't always be that way. The world of volatility products is undergoing a fairly rapid metamorphosis with the impending adoption of two profound adjustments. The first, which manufacturers are already incorporating into their models, strategies and indexes, are techniques to mitigate the cost of carry. Short-term volatility products looked good at first, but market predictions that volatility will continue to rise means that profit (and more) from products has been spent on carry costs. Fear not - for those buy and hold investors unaccustomed to trading their book on a regular basis, new and improved volatility models that account for this cost are already here.

The second problem is the way that volatility is often sold in the form of an exchange-traded note (ETN). While ETNs are neat and tidy structured products, they are subject to issuer risk, which remains a vital consideration in investment decisions. So look out for the ETN that comes with its very own collateral support to assuage all those fears over bank credit quality.

And on the subject of collateral, Andrew Malcolm, a partner at Linklaters in Hong Kong, has noted an unexpected side effect to the love affair that regulators are enjoying with this tool of credit enhancement. Introducing collateral into any investment product instantly adds or creates complexity, which is exactly what all regulators have been declaring for so long that they are trying to avoid.

Introducing collateral into any investment product instantly adds or creates complexity, which is exactly what all regulators have been declaring for so long that they are trying to avoid

The logical conclusion would be regulators accepting that some ‘complexity' is acceptable and even desirable.