Russell Investments has introduced a series of indexes designed to allow fund managers to control volatility in their portfolios.

The indexes will allow managers to control their volatility by setting parameters to an algorithm which will shift the assets in a portfolio between two benchmarks, an underlying index and a cash investment, depending on how much volatility it calculates in the securities index. The proportion of the volatility control index allocated to the underlying index and cash investment is determined by the index’s algorithm imbedded in the methodology. The allocation will depend on the index’s target volatility and the observed volatility of the underlying index.

Managers will go through a series of steps in customizing their indexes, according to Russell.

First, each will choose a particular level of volatility.

Then, the manager will choose a method for calculating the volatility, which, for example, could be simple-weighted or exponentially-weighted. Simple-weighted volatility calculation is one method for calculating the observed volatility of the underlying index. The observed volatility is then compared to the target volatility to determine the index’s allocation to the underlying index and cash investment. This volatility calculation uses a simple-weighted moving average based on the variance of the daily total performance with a short-term tenor of one month. Each observation is weighted equally, according to Ken O’Keeffe, Managing Director of Investable Products at Russell Investments

Meanwhile, O’Keefe says that an exponentially-weighted volatility calculation is another method for calculating the observed volatility of the underlying index. This volatility calculation uses an exponentially-weighted moving average which incorporates a decay or smoothing factor that determines the weighting of each return within the variance component of the volatility calculation. As a result, more recent observations are given a higher weight in the volatility calculation.

The manager then chooses the underlying benchmark for the non-cash portion, which can be any Russell Global or US Index.

Next to be selected is the cash investment component, which is typically defined as a money market rate such as the London Interbank Offered Rate (LIBOR).

Finally, the manager chooses the amount of leverage involved and schedules for rebalancing the components held in the portfolio for the investment index portion.

In theory, an algorithm operating at the heart of these indexes will watch over volatility and move assets between the benchmarks accordingly, limiting risk during times of high movement and allowing for maximum exposure to the market when things grow calmer, says the Russell statement.

Currently, the indexes come in six types.

These include the Russell 2000 Daily Volatility Control 10% Total Return and the Russell 2000 Daily Volatility Control 10% Excess Return. A total return index calculates the actual rate of return of an investment or a pool of investments over a given evaluation period. Total return includes interest, capital gains, dividends and distributions realized over a given period of time. An excess return index calculates investment returns from a security or portfolio that exceed a benchmark or index with a similar level of risk.

Russell offers versions for 12 percent and 15 percent levels of target volatility. These figures, 10%, 12% and 15% represent examples of the target volatility level of the index. The target volatility is the volatility level that the index will strive to maintain based on its allocation between the underlying index and the cash investment. It is defined by the end client based on their level of risk tolerance allowing for index flexibility and customization. Russell Indexes currently has indexes in production targeting 10%, 12% and 15% volatility.

As prices begin to swing, the Russell Volatility Control Indexes would shift away from the pre-selected underlying index and move towards the cash investment, and similarly, when the volatility falls, they would move away from the cash and increase its exposure again to the underlying index.

“We view these new indexes as a way to help clients better implement a managed volatility portfolio strategy through the efficient, rules-based approach of a market index,” said Rolf Agather, managing director of global research and innovation for Russell Indexes.

Tommy Fernandez writes for Money Management Executive.