Volatility as an asset class: Rethinking defensive allocation in modern portfolios

“The safest way to be rich is to survive.” – Mark Spitznagel, founder, owner and chief investment officer at US-based hedge fund Universa Investments.

For much of the last four decades, the 60/40 portfolio (equities for growth, bonds for defence) served as the institutional cornerstone. This model benefited from a persistent negative correlation between stocks and bonds, driven by disinflation and a secular decline in interest rates.

That regime is now in question. In 2022, both equities and bonds suffered deep declines: the MSCI World Index sank 18 per cent while the Bloomberg Global Aggregate Bond Index dropped 6 per cent, marking one of the worst years for balanced portfolios in history. The presumed diversification of the 60/40 portfolio broke down precisely when investors needed protection most.

As mathematical statistician and financial author Nassim Taleb has long argued, “You can be wrong about everything and still make money if you are prepared for the unexpected.” Volatility, as an asset class, is designed to benefit from precisely those moments of stress, yet remains under-utilised by many institutional and private investors.

The empirical equity–volatility relationship

A central feature of markets is the asymmetric link between equities and volatility. A large body of research (Black, 1976; Christie, 1982; Ang, Hodrick, Xing & Zhang, 2006) documents that equity declines are consistently associated with sharp spikes in implied and realised volatility.

This convexity is embedded in option markets. When equities sell-off, demand for downside protection pushes up implied volatility, especially in out-of-the-money put options. Bollerslev, Tauchen & Zhou (2009) demonstrate that volatility risk innovations are priced into future equity returns, underscoring volatility’s role as both a ‘state variable’ (reflecting the current market environment) and a tradeable risk premium.

For investors, this means long-volatility allocations tend to deliver positive payoffs during stress: what Spitznagel at Universa calls “crisis alpha.”

Volatility as a diversifier and crisis hedge

Empirical evidence supports the role of volatility as a diversifier:

• Convex payoffs in crises: Long-volatility strategies produced outsized returns during the Global Financial Crisis, when equities collapsed. Ardia et al. (2016) and Feunou, Jahan-Parvar & Tédongap (2013) confirm that long-volatility exposures generate convex, asymmetric payoffs negatively correlated with signifcant drawdowns.
• Weak link to bonds: Unlike bonds, whose hedging efficacy depends on deflationary shocks or central bank action; volatility strategies perform across both inflationary and deflationary crises.
• Portfolio efficiency: defensive option overlays materially improve portfolio Sharpe, Omega and CVar ratios by reducing tail risk without foregoing upside.  For long-term investors; the power of compounding returns is better realised.
• Systemic risk cannot be diversified away : Diversification alone cannot defend a portfolio during systemic market failure, which sees virtually all asset classes experience high correlation (“correlations go to one.”) Long-volatility stands alone in these periods.

The critique that volatility exposure is “too complex” ignores both decades of academic research and a growing body of practitioner experience. Complexity is not a weakness; it is often the source of diversification benefits. Further, most nay-sayers typically point to ‘naive’ static option purchase programs when comparing performance. Instead, investors should evaluate a broader set of specialist volatility managers, dynamic strategies or tactical use.

Tactical overlays and tax-efficiency

For taxable investors, the case is even stronger. Selling equities to de-risk a portfolio at elevated valuations typically crystallises capital gains tax (CGT). Tactical derivative overlays – protective puts, option spreads, or index futures – reduce equity beta without forcing asset sales.

This allows investors to:

• Defer CGT liabilities.
• Preserve long-term compounding.
• Maintain higher structural allocations to growth assets while still managing risk.

As hedge fund luminary Paul Tudor Jones remarked, “Don’t focus on making money, focus on protecting what you have.” Well-designed overlays allow investors to do both.

Why now feels like the GFC

Today’s environment has parallels with the Global Financial Crisis: rising leverage in parts of the financial system, sharp policy pivots, and clustering of risk premia across asset classes. Correlations are again rising in stress, while liquidity in options markets has thinned – a recipe for convex outcomes.

This backdrop has drawn veteran volatility specialists back into the arena. Steven Diggle, who co-founded Artradis (one of Asia’s most successful volatility hedge funds during the GFC), recently re-emerged with a new volatility strategy. The return of such managers underscores the sense that markets are again approaching regime extremes.

Practitioner perspective: 20-plus years in volatility

As a volatility manager for over two decades, I have researched and traded volatility across equity, FX, fixed income, and commodity markets. Over that time, the asset class has evolved, but one principle remains: volatility is one of the few exposures that consistently gains when conventional allocations lose.

Today, Australian investors can gain access to efficient portable alpha solutions which embed long-volatility features available within wholesale trusts. These structures make volatility exposure more practical, transparent, and capital-efficient than in the past.

Fundlab, regularly reviews these alternative solutions and can provide added information where needed.

Strategic role of volatility: The “third pillar”

Artemis Capital Management founder Chris Cole’s “Dragon Portfolio” (2020) captures volatility’s role in a multi-regime allocation: equities perform in prosperity, bonds in disinflation, real assets in inflation, and volatility in crises. Ilmanen (2011) makes the same case academically: true diversification requires exposures that thrive across divergent macro environments.

Portfolios without volatility are effectively short-convexity – fragile when multiple asset classes correlate under stress.

Conclusion: From Fragility to Antifragility

The failure of 60/40 to defend portfoliso in the 2020s highlights the need for a third defensive pillar. Empirical evidence shows volatility strategies:

• Deliver convex payoffs in crises.
• Diversify across macro regimes.
• Improve portfolio efficiency.
• Provide tax-aware defensive tools for taxable investors.

As Taleb (2012) wrote in Antifragile: “The fragile breaks with the unexpected. The robust resists it. The antifragile gets better.”

Volatility, far from being an exotic sideshow, may be the most anti-fragile allocation investors can embrace.

Michael Armitage CAIA is principal of Fundlab Strategic Consulting Pty. Ltd.

Disclaimer: This article is provided for informational and educational purposes only and does not constitute financial product advice, investment advice, or a recommendation to buy or sell any security, derivative, or investment strategy. The views expressed are those of the author and are based on information believed to be reliable at the time of writing, but no representation or warranty is made as to accuracy, completeness, or fitness for purpose. Past performance is not indicative of future results. Readers should seek their own independent legal, financial, tax, or other professional advice before making any investment decisions.