All volatility-controlled indices are NOT created equal
February 10, 2016 by Daniel W. McDonald
As index annuities gain popularity, competition for market share is fierce, and volatility-controlled indices have become an industry standard — but how do they actually work? All volatility-controlled indices are, in fact, not created equal to highlight the difference of each index and not to prove if one index is better or worse than another (that’s for you to decide). Below is an objective overview of volatility-controlled indices in general, carrier specific offerings and how they came into existence.
How does a volatility-controlled index actually work?
Each volatility risk controlled index is linked to an underlying volatility index. A key difference is the inclusion of a percentage number (usually 5 percent, 7 percent, or 10 percent). The higher the percentage numbers the higher the allowed level of volatility, which offers greater upside and downside potential. Each volatility index is comprised of individual stocks or entire broader indexes typically rebalancing allocations monthly and adjusts exposure to the underlying index daily. Depending on the construction of the index’s algorithm certain levels of volatility will increase or decrease an allocation from one internal index to another or alter the exposure percentage of the overall volatility-controlled index. Specific underlying and risk controlled volatility indexes will be explained later.
How does a spread work and how are they applied?
In the world of volatility controls linked to uncapped strategies we almost assuredly will talk about spreads. Please note that spreads are not fees as they only apply to gains and will not diminish principal or account value as a fee would. Below is an example using a 3 percent spread.
- (16% index gain) – (3% spread) = 13% credited to account
- (2% index gain) – (3% spread)= 0% credited to account
- (-8% index loss) – (3% spread)= 0% credited to account
How large the spread is and how high it can go once the contract is issued is important to know?
As indicated in the title, all volatility controls are not created equal, which is not only true with how the actual index is constructed, but also how the spread works. For example, Genworth’s strategy is a 2-year point-to-point with a current spread of 1.65 percent applied annually and can be increased to 6 percent. Whereas, Eagle Life’s spread is 1 percent and can increase to 10 percent, and Forethought’s spread is 6 percent, can be increased to 15 percent and applied tri-annually.
Editor’s note: After this article was written, Genworth announced their suspension of traditional life coverage and fixed annuity products. Read more on our sister site, LifeHealthPro.com.
Do you know what you’re selling?
Below are five of the industry’s most popular index annuity companies and their respective volatility-controlled, uncapped strategies. Knowing how they work and how they’ve performed in decreasing/increasing markets and interest rate environments is vital to advisor and wholesaler credibility alike. The numbers below can be publicly viewed using the link provided for each strategy and the descriptions of the index are provided by each company on their website or in approved client material. Carriers and indexes are listed in order based on 5-Year Annualized Return after current spread.
Index Name: Barclays US Low Volatility II ER Risk Controlled Index7% (Ticker: BXIILVU7)
Indicies Used: NYSE & NASDAQ
- 2013 Total Return: 20.04%
- 2015 Total Return: -0.31%
- 5-Year Annualized Return: 7.52%
The Barclays US Low Volatility II ER Risk Controlled Index 7% is a volatility controlled index that tracks a basket of 50 of the lowest volatility stocks on the NYSE and NASDAQ. Stocks must also have a market cap of $5 billion and have a three-month average daily traded value of $50 million or greater to qualify. On a daily basis, the index increases or decreases the exposure to the basket of stocks in order to target a 7 percent volatility level. The basket of stocks is rebalanced monthly and consists of 50 of the lowest volatility stocks from the past 12 months. This index is a two-year point-to-point and a monthly fact sheet is available for this index.
Index Name: S&P 500 Dividend Aristocrats Daily Risk Control 5% Index (Ticker: SPXD5UN)
Indices Used: S&P 500 Dividend Paying
- Stocks & Cash Component
- 2013 Total Return: 13.13%
- 2015 Total Return: -1.10%
- 5-Year Annualized Return: 4.66%
The S&P 500 Dividend Aristocrats Daily Risk Control 5% Index is designed to measure the performance of large cap, blue chip companies within the S&P 500 that have followed a managed-dividends policy of consistently increasing dividends every year for at least 25 years. Constituents must have a float-adjusted market cap of at least $3 billion and an average daily value traded of at least $5 million for the three months prior to the rebalancing reference date. At each daily rebalancing, the minimum number of constituents should be 40. The index also features a risk control element. On a daily basis, S&P allocates a portion of the invested funds into an interest accruing cash component to maintain a target volatility of 5 percent. This index is a one-year point-to-point and a yearly fact sheet is available for this index.
Index Name: ML Strategic Balanced Index (Ticker: MLSB:IND)
Indices Used: S&P 500 & Merrill Lynch 10-Year Treasury Futures Total Return Index
- 2013 Total Return: 2.86%
- 2015 Total Return: -1.41%
- 5-Year Annualized Return: 5.56%
The Merrill Lynch Strategic Balanced Index blends equity and fixed income indices to seek an attractive level of return for a given level of risk. A non-discretionary, rules-based process is used to adjust exposures to the S&P 500® Index and the Merrill Lynch 10-Year Treasury Futures Total Return Index. This process may help the index generate positive returns while meeting a target volatility level. Index weightings are reviewed and rebalanced every six months based on the historical volatility of the index. As an additional measure of risk control, cash positions may be increased or reduced daily to help maintain the overall volatility of the Index at 6 percent. This index has an one and two-year point-to-point option.
Index Name: Barclays US Dynamic Balance II Index (Ticker: BXIIUDB2)
Indices Used: S&P 500 & Barclays US Aggregate RBI Series 1 Index
- 2013 Total Return: 7.74%
- 2015 Total Return: -2.88%
- 5-Year Annualized Return: 4.13%
The Barclays US Dynamic Balance II Index reflects the performance of an index strategy that uses the S&P 500 Index and the Barclays US Aggregate RBI Series 1 Index. The Barclays US Aggregate RBI Series 1 Index is comprised of a portfolio of derivative instruments plus cash that are designed to track the Barclays US Aggregate Bond Index. Every day, the Barclays US Dynamic Balance Index II dynamically allocates between the S&P 500 and Barclays US Aggregate RBI Series 1 Index based on their historical realized volatility. Weighting in the aforementioned indexes shifts daily, up to 3 percent, based on the greater of the 20 or four-day realized volatility of each index. The realized volatilities are used to determine the final weight allocation daily. This index is a one-year point-to-point.
Index Name: Barclays ARMOUR II Gross USD 7% ER Index (Ticker: BXIIAG7E)
Indices Used: S&P 500 Total Return Index, iShares MSCI Emerging Markets Fund, S&P GSCI Total Return Index, SPDR Gold Trust, Barclays US 10yr Treasury Futures Index and USD Libor 1-month
- 2013 Total Return: 3.01%
- 2015 Total Return: -20.92%
- 5-Year Annualized Return: -1.71%
The ARMOUR II Gross USD 7% ER Index incorporates a multi-asset allocation strategy that attempts to adaptively allocate assets in accordance with a quantitative model to deliver returns. The strategy is applied to a set of assets from 6 different asset classes: Developed equity, emerging market equity, commodities, gold, bonds and cash. On a daily basis, the strategy allocates a portion to cash to maintain a 7 percent target volatility. The remaining allocation is split between the two best-performing asset classes based on the previous month’s actual performance of each class. The strategy allocates 60 percent to the best performing asset class and 40 percent to the second-best performing asset class. The strategy adapts its allocations on a monthly basis as it strives to capture changing trends. This index is a three-year point-to-point and a monthly fact sheet is available for this index.
Who created the volatility-controlled index?
We the clients, advisors and wholesalers, in essence, indirectly created these indices when we demanded for protection of our assets, and greater upside potential than a traditional cap or fixed rate could provide. As stated at the beginning, “as index annuities gain popularity competition for market share is fierce, and volatility-controlled indices have become an industry standard. This article aimed to show you that all volatility-controlled indices are, in fact, not created equal to highlight the difference of each index and not to prove if one index is better or worse than another.” In an industry of uncertainty, selling certainty, at least one thing remains certain: Insurance carriers are more than willing to compete for your business. Ask and you shall receive. However, ask wisely and be prepared to learn as your industry advances or you will be left behind. That is true with any career and in any sales-driven field.