Benchmarking Convexity: Towards a Holistic Approach

Anthony Limbrick and Siva Naguleswaran

In this chapter, we will reinterpret some of the classic models of price dynamics in financial markets in order to develop an adequate framework from which to build appropriate benchmarks for strategies with convex payouts: namely, volatility, trend-following and tail risk strategies. To be clear, we will not specify a benchmark as such, but rather point investors towards a new approach to building their own. Our second objective is to help readers to understand and differentiate between the concepts of “directionality” and “volatility” as they are applied to analysing and benchmarking convex strategies.

For managers of volatility, trend-following and tail risk strategies, there are no standard definitions or widely accepted benchmarks. In the past, some managers would point to beating a zero return as proof of success, others would use Treasury bills or Libor as hurdle rates, while yet another group of managers would often compare their results to equity returns. However, arguably, none of these are “like-for-like” comparisons, and the challenge is especially daunting in the case of managers who are structurally long volatility. Because the majority of all options “struck” across