INTRODUCTION
In this paper, we introduce the new S&P 500® Futures Daily Risk Control 5% Index (the Risk Control 2 Minimum Variance), which is the latest enhancement to S&P DJI’s Risk Control 1 (RC 1) and Risk Control 2 (RC 2), and a variation on our existing standard RC 2 methodology.[1]
Our risk control techniques began with RC 1, which allocates to equity and cash to achieve a target volatility. RC 2 then introduced fixed income as another asset class and allocates between an equity and liquid bond index to target a specific volatility. The bond sleeve in RC 2 is generally a risk reduction tool. However, in volatile periods when no suitable combination of equity and fixed income is able to attain the target volatility, RC 2 rotates its bond sleeve completely to cash, thereby defaulting to RC 1.
In this new index, we take RC 2 a step further, to RC 2 Minimum Variance. We allocate to equity and bonds like RC 2; however, unlike RC 2, we introduce cash as an extra alternative rather than a complete swap when underlying volatility picks up.
WHY A NEWER VERSION OF RC 2?
Though RC 2 takes the RC 1 approach a notch higher by introducing bonds, it still has one shortcoming. In instances when the volatility target is relatively too low (i.e., during periods of sell-off), the bond sleeve of RC 2 switches completely to cash.
While allocating to cash reduces index volatility, thus bringing it in line with the target, this comes at a cost of higher turnover resulting from this bond-to-cash swap. Our new optimized approach addresses this problem through its innovative technique and significantly reduces turnover.
