At the core of modern finance is the claim that risk and return are tightly linked. Higher performance is joined at the hip with higher risk. History suggests that's a pretty good description of general market behavior in the long run, but the relationship can become unstable over a span of weeks or months. In fact, you can count on it.

That's the main glitch with conventional finance theory, and one that's likely to cause trouble for the average investor. It's no picnic for financial advisors and other professionals, either. But it's not all darkness and doom. Sometimes the glitch works in our favor. In 2007, for instance, the equity market's trailing volatility (its standard deviation of return) plunged while performance soared. No one was complaining, though the arrival of one extreme is a reminder that its evil twin may be lurking. For anyone who thought otherwise, the events of late 2008 forced an attitude adjustment.

A disciplined investor who's truly focused on the long run may be able to ignore the short-term noise and wait for the risk-return relationship to right itself. If you're tactically inclined, maybe you can exploit the bouts of instability with clever trading. Alas, both approaches have their limits for most folks. In the long run, we're all dead, as Keynes famously quipped, and talented market timers are a rare breed otherwise.

Fortunately, there's a third choice: diversifying across asset classes. As the standard approach to risk management, asset allocation works just fine-most of the time. But every so often, perhaps more often than generally assumed, the conventional defense is defenseless. The market "is a learning machine that continually errs, corrects itself and makes new errors," writes Kent Osband in Pandora's Risk: Uncertainty at the Core of Finance, an intriguing new book that re-examines assumptions about market behavior and financial risk.

The limits of standard risk management inspire supplementing asset allocation with hedging strategies that offer some protection against periods of "learning." If you're not going to be compensated in a timely manner for suffering higher volatility when the market crashes, there's a case for insuring against this unrewarded risk. Unfortunately, implementing this concept is complicated.

The Risk Of Managing Volatility
One danger is going overboard. Because risk and return are linked, you can only minimize volatility so far before expected return tumbles as well. Another hurdle is keeping a lid on expenses and the opportunity cost that often accompanies hedges. There's no shortage of products for shaving risk, but the price tag isn't always reasonable.

It's easy to curtail the downside risk for an equity market allocation by adding, say, put options or short-strategy ETFs. Another possibility is buying one of several exchange-traded products that track the CBOE Volatility Index, or VIX. It's often called the fear index because it measures the implied volatility of the S&P 500. When stocks crumble, the VIX tends to jump, as does a simple measure of volatility (standard deviation). But the problem with a straight hedge by way of a volatility proxy, or a short-strategy ETF, is the hefty opportunity cost when investors use it as a buy-and-hold strategy.

Consider the history of the VIX versus the S&P 500 (Figure 1). A $100 investment in the U.S stock market for the 20 years through this past May would have grown to roughly $370. The same buy-and-hold investment in the VIX would be more or less unchanged over the last two decades. That's a horrible return for such a long period, but it's not surprising.

Finance theory tells us not to expect a risk premium for holding volatility. Sure, prices of stocks and other asset classes bounce around a lot, but the volatility levels usually end up as a wash in the long run. The price tag is even higher after factoring in the various costs of securitizing volatility. For instance, several exchange-traded notes (ETNs) that track several incarnations of equity market volatility have pricey expense ratios of 0.85% to 1.65%, according to Morningstar Principia. By comparison, you can buy a broad equity market ETF for under 0.1%.

But let's not be hasty. Volatility may be a dog as a buy-and-hold proposition, but its negative correlation with return is a powerful antidote for market crashes. Ideally, you'll buy the VIX on the eve of a crisis.

Carol Alexander and Dimitris Korovilas, at the U.K.'s University of Reading wrote about the problem in a recent working paper, "The Hazards of Volatility." "The problem is," they wrote, "that such crises are extremely difficult to predict and relatively short-lived. In other words, equity volatility is characterized by unexpected jumps followed by very rapid mean reversion, so expectations based on recent volatility behavior are unlikely to be realized." Once it's clear that a new crisis is here, "it is usually too late to diversify into volatility," they warned.

A Solution?
Enter a new breed of hedging strategies that are intent on preserving volatility's natural contrarian profile during market crashes without breaking the bank as a long-term holding and perhaps even turning a modest profit over time. Easier said than done, but several investment banks are now selling products linked to indices that are designed to offer a solution:
Deutsche Bank's "Emerald" index (short for "Equity Mean Reversion Alpha") is one example. Another comes from Barclays, which recently began offering a competing product tied to its Astro Index (short for "Algorithmic Short Term Reversion.") BNP Paribas is also a player in the niche, although it hasn't yet started selling a direct competitor to Emerald or Astro in North America.

These benchmarks can theoretically be tied to any standard market index by way of structured notes sold by the sponsoring bank. The most popular pairing is with the S&P 500, a proxy for the U.S. stock market. In that case, an investment in Emerald or Astro delivers the return of the underlying benchmark plus the performance of the S&P 500, less expenses. You can think of it as an enhanced S&P 500 index fund that seeks to limit the extremes of a market crash without materially reducing the stock market's long-run expected return.

Thanks to the turmoil in the wake of 2008, there's broad appeal for the likes of Emerald and Astro. "The market collapse in late '08 is what started us down this road," says Jerry Miccolis, chief investment officer at Brinton Eaton, a Madison, N.J., wealth manager that holds Emerald- and Astro-based products in client portfolios.

Joe Scarpo, chief executive officer of Private Wealth Advisors in Pittsburgh, describes a similar search that led his firm to recently allocate a portion of client assets to Emerald. "We were looking for some type of alternative that gives us the opportunity to profit from market volatility," he says.

At the heart of Emerald, Astro and comparable rules-based strategies is an expectation (some might call it faith) that mean reversion in market returns will prevail. Above-mean performance tends to lead to below-mean returns, and vice versa. Laurence Black, director of quantitative indices and strategies at Barclays in New York, summarizes the Astro Index as a strategy offering "access to mean reversion in volatility, which historically has worked well in times of market stress."

The strategic engine for tapping mean reversion in Emerald and Astro is the continual coupling of a long position in daily S&P 500 volatility with the shorting of the stock market's weekly level of volatility. Think of the long side of daily volatility as comparable to owning the VIX. If the stock market tanks, volatility is likely to spike. Thus, the daily long volatility trade will provide the heavy lifting for offsetting a loss in a market crash. But, as noted above, a dedicated allocation to long-only volatility alone will likely be costly in the long run.

That's where the short weekly volatility position helps. This part of the strategy is designed to neutralize long volatility's high cost on a buy-and-hold basis. The short position's goal amounts to financing the long-term holding costs that accrue with long volatility. The assumption is that the sum adds up to more than the parts.

A Closer Look At The Short Side
Selling volatility as a stand-alone trade is no stranger to researchers or traders, nor is it beyond the pale to describe it as a profitable strategy in its own right-most of the time. A market crash can devastate traders with naked short volatility positions. But if crashes are rare, expected return is generally positive for short volatility positions over time.

That's because the market generally prices volatility at a premium relative to the actual level of volatility in market history. In other words, volatility is generally priced too high compared with the level that's likely to prevail. Selling volatility, as a result, allows traders to capture the premium. Presumably, buyers of volatility are willing to pay a premium for the same reason that people buy home insurance and understand that there's a price for protecting assets.

For example, the VIX's implied estimate of S&P 500 volatility has averaged roughly 19% from 1990 to 2007, according to a study by Bjorn Eraker, a finance professor at the Wisconsin School of Business ("The Volatility Premium.") Yet the historical annualized standard deviation of the S&P 500 has been much lower during that period: roughly 15.7%. The 3.3 percentage point difference suggests that the expected premium for writing options (selling volatility) on the S&P 500 is "substantial," Eraker notes.

As for the short volatility positions in Emerald and Astro, the more immediate factor is the historical bias for mean reversion in stock returns in the short term. To the extent that this reversion endures, daily volatility is likely to exceed weekly volatility. If so, the long daily/short weekly volatility spread will be positive, which might mean a modest positive return.
Since mean reversion is crucial for the strategy, it's reasonable to wonder if it's likely to persist. A number of studies tell us that the evidence is encouraging. An early example is Werner DeBondt and Richard Thaler's 1985 study, "Does the Stock Market Overreact?" (in the Journal of Finance, July 1985). Yes, they answer. Scores of subsequent studies report similar results.

But let's be clear: Emerald and Astro are counting on mean reversion during relatively short periods. There's plenty of supporting evidence here as well, including a 1990 paper that shows that stock portfolios with positive returns in one week "typically" suffer losses the next, and vice versa ("Fads, Martingales, and Market Efficiency," by Bruce Lehmann, in the Quarterly Journal of Economics, February 1990).

Faith In The Past
The track records for these strategies are limited, but recent history suggests that mean reversion works. The Emerald index, for instance, compares favorably with the stock market from the period just ahead of the late-2008 crisis (FigureĀ  2). Emerald has outperformed the S&P 500 by a wide margin for the four years through the close of this past May.
It also acted as a hedge when stock prices sank and volatility surged in the crisis. And Emerald did not give up its gains once the market stabilized (Figure 2). Such a wide divergence won't prevail over time, but recent history at least offers some perspective after a period of extreme market volatility followed by relative stability.

But this is no free lunch. A key test of Emerald was an extraordinary eight-day run of nonstop losses a few years ago for the S&P 500, which appears only as a brief drop in Chart 2. This was arguably the worst point of the crisis, cutting the S&P by nearly 23% in the eight trading days through October 10, 2008. Emerald also took a dive, giving up nearly 15% in that stretch.

Mean reversion, in sum, was MIA for eight days. Keeping the faith in this hedge required steely discipline and a strong conviction in mean reversion's powers of perseverance. As it turned out, mean reversion revived on the ninth day with October 13's powerful single-day 6.8% rise in the stock market.

This past summer witnessed another stress test, when the S&P 500 swooned during a white-knuckle ride that left stocks lower in 10 out of 11 trading days in late July and early August. Once again volatility's mean reversion disappeared for an unusually long stretch, pushing the strategy's viability to the limits along the way. But the selling wave eventually subsided, and volatility's "normal" daily/weekly relationship revived on the 12th day.

How does one muster the confidence that mean reversion will continue to triumph? A fair amount of data crunching of the historical record helps. "We got the formula [for Emerald] and programmed it ourselves," says Miccolis. "We looked at how it behaved. If we can't reproduce it in our own spreadsheets, we don't trust it."

Scarpo's firm also put the numbers through extensive testing, reviewing how Emerald's subsequent three-year results looked from each and every date from 1998 onward. Of the several thousand start dates, only one-half of 1% of the three-year results for Emerald turned in a lower return compared with owning the S&P 500 on its own, says Kevin Comstock, a research analyst at Private Wealth Advisors.

Another key issue is the scaling factor, an optional form of leverage that increases the magnitude of returns or losses, but without the complications or risks typically associated with conventional leverage via borrowed money. For example, Private Wealth Advisors holds Emerald notes for clients with a scaling factor of two; Brinton Eaton opts for a factor of three. Scaling amplifies results, for good or ill, but it also provides a risk-control benefit because it reduces the absolute level of dollars needed to generate a given return/risk profile with the strategy. That's an issue since Emerald's and Astro's results are delivered through notes issued by their respective investment banks, so there's a degree of credit risk to consider. As a result, fewer dollars invested through a single institution promotes diversification.

Another consideration is an SEC regulation that requires the return of any remaining capital to investors when the notes lose two-thirds of their value. The potential risk of forced liquidation during a run of market losses increases with a higher scaling factor. There's also a higher expense ratio as scaling rises. PWA paid a one-time 60-basis-point fee for Emerald, and there's another 1% due for each level of scaling, says Comstock. A scaling of two times, for instance, incurs a 2% fee.

For all the encouraging analysis, some advisors remain skeptics. Michael Edesess, the chief investment officer and founder of Fair Advisors in Denver and the author of The Big Investment Lie, opines in a recent e-mail that Emerald and similar strategies run afoul on two fronts by his reckoning. "One is the good old engineering dictum K.I.S.S. (keep it simple, stupid)." The other is putting too much faith in mean reversion, he writes. "There is no law in financial markets saying that patterns of 'mean reversion,' or whatever that can be statistically observed in historical data, must continue to be observable in future data. So any product that rests on that assumption is on shaky ground."

Perhaps, but in a world hungry for innovation in risk management after the 2008 financial crisis, demand is rising for the likes of Emerald and Astro. Still, it's no surprise that even advisors who are intrigued aren't always in a rush to jump in. Emerald is "interesting," says Chris Cordaro, chief investment officer at RegentAtlantic Capital, a wealth management shop in Morristown, N.J. "It works most of the time, and it's fairly low cost," he says of the strategy, but "it's not going to work all the time." He doesn't rule out using Emerald and Astro in the future. Meanwhile, "we've become far more tactical in our asset allocation. Your better protection is buying asset classes that are cheap, and staying away from those that are pricey."