To: Investment Committee, Generic Insurance Company Singapore

From: Agent X, Investment Manager

Subject: Feasibility Study of Using Volatility Index for Tactical Asset Allocation (TAA)

This memo outlines the preliminary feasibility study in using the Chicago Board Options Exchange
(CBOE) Volatility Index as a tool to control the tactical asset allocation within the company specifically the
equity portion of asset holdings.

The contribution into the equity holdings on shareholder (non-unit) account is from the participating
product fund (savings product with policyholder profit participation) whereas non-participating product
(protection products) and non-unit investment-linked product fund are both only invested into fixed income
asset. Unit account from investment-linked funds is separately managed by an external fund manager
thus is not within the scope of the study.

As the main bulk of equity holding within the participating fund is local corporate equity, I will use the
Straits Times Index (STI) as the main gauge of the performance of equity. This index consists of 30
representative listed companies on the Singapore Exchange. I did a goodness-of-fit and tracking test on
our gross historical return versus the index and the fit is very good.

Choice of Index
There is no specific volatility index to cater for the STI so I have chosen the S&P500 Volatility Index (VIX)
as our proxy for the study. This index is chosen over the Nasdaq Volatility Index (VXN) and Dow Jones
Volatility Index (VXD) because the former’s underlying consists of non-financial companies (can be non-
US as well) while the latter’s consists of 30 large public companies within the US. The fit and correlation
using S&P 500 is fairly consistent (see Chart 1 in Appendix) except the period from 1997 to 1999 whereby
STI trailed other major indices due to the Asian Financial Crisis causing significant non-correlation and
spread between STI and other indices.

Analysis of Result

I have performed a simple analysis by assuming that TAA will be performed by observing volatility index
(see Chart 2) of the previous day and if the index is greater than 30, all the exposure will be moved into
money market whereby the equity position will theoretically remain the same. This is done assuming
market liquidity is not an issue and cost of transactions are not taken into account. The modified STI
indexed will be notated as STI^. VIX has been established since 1990 therefore we have 20 years of data
to backtest.

Backtesting results (see Charts 3-5)

Period STI Final STI^ Final Outperformance Days hedged/

(per annum) exposure ratio
5 Year 2913.25 3005.11 0.6% 15.3%
10 Year 2913.25 4481.75 4.4% 14.5%
20 Year 2913.25 4639.80 2.4% 9.5%

VIX has been particularly volatile in the recent years therefore the number of days hedged is higher
compared to over 20 year period. The strongest outperformance is shown when there is a global
economic crisis – the VIX has been able to assist in identifying and hedging significant market downturns
during the volatile market.
The main differences that caused significant outperformance of the 10 year test comparatively are:
- 5 year testing was not exposed to prior downturns and the most significant outperformance came
around 2001. The 2007 downturn saw very high market volatility such that the market rebound is not
captured by the VIX parameter thus outperformance is insignificant.
- 20 year testing was exposed to the Asian Economic Crisis circa 1997 which we were not able to
hedge as VIX is not able to capture the Asian market downturn because the US market is not affected
significantly

Pros of Using VIX

1) Strong market correlation

Due to the strength of the economy and capital market in US, it generally has a strong impact on the
STI therefore leading to a strong market correlation. If we are able to identify leading economic
indicators and market trend within the VIX, we can position ourselves better to capture equity growth
assuming a well diversified portfolio and tracking of the STI.

2) Identify high volatility

By tracking the change in volatility and following market happenings, we can potentially predict market
movement. We can easily identify periods of market instability especially downward trend from past
experience. The simple test done easily brought convincing improvement over the original index.

Cons of Using VIX

1) Regional/ local exposure

As demonstrated by the comparison of the local and US indices, although we expect a close tracking
of the performance of STI to S&P 500, there will still be some mismatch. This example is shown as of
the Asian Financial crisis in 1997 whereby STI severely underperform S&P500 and this was not
captured by the VIX due to the difference in climate regionally.

2) Not capture all upside potential

A high volatility does not necessarily means that “investor fear” is high; instead it means that the
implied volatility of options is high and market can be on the ascent. This is demonstrated by the
period of high volatility in year 2008 to 2009 due to the economic crisis. Further analysis and manager
input could help to identify opportunities to participate in the market rebound.

Conclusion

As the information provided by the VIX can be double-edged, care is needed in the implementation of the
TAA controls to avoid pitfalls mentioned and to augment its capability.

With additional refinement by implementing a tiered/ staggered equity participation dependent upon VIX
level and supplemented by other market trending or study, we would be able to hedge effectively to avoid
market downturns as proven by this simple preliminary feasibility study. The strength of using the VIX is
shown particularly in global market downturns whereby strong outperformance is captured by avoiding
participation in volatile downward market.
Appendix
Data sourced from Yahoo Finance®

Chart 1: Market comparison of Major Indices (Log Chart)

Chart 3: Volatility Index of S&P500 (VIX)

Chart 3: STI versus modified STI 5 year backtesting (2005 – 2009)

Chart 4: STI versus modified STI 10 year backtesting (2000 – 2009)

Chart 5: STI versus modified STI 20 year backtesting (1990 – 2009)