CFA Institute Journal Review August 2013 Volume 43 Issue 3
The Different Faces of Volatility Exposure in Portfolio Management (Digest Summary)
Journal of Alternative Investments
Tradable volatility exposure has matured as an asset class to be considered alongside such traditional asset classes as equity, fixed income, cash, and alternative investments. Its unique properties and characteristics make it attractive not only for risk reduction but also for profiting from shifting volatility expectations.
The author begins by examining the unique characteristics of realized (or historical) and implied volatility along with the various tradable vehicles that enable volatility exposure. This approach serves as the platform for an appraisal of the investment applications of tradable volatility and its flexibility as both a risk modification tool and an avenue to profit from volatility expectations. The author examines how the addition of short-term and medium-term volatility exposure to a portfolio transforms its risk–return profile and then compares the results with other approaches that modify portfolio risk. The conclusion is that for longer-term investment horizons, mid-term Chicago Board Options Exchange Volatility Index (VIX) futures and futures options are effective risk modifiers and can modify risk with less capital than fixed-income securities.
How Is This Research Useful to Practitioners?
With the global financial crisis of 2008 still fresh in investors’ minds, the motivation to uncover more effective ways to manage risk is strong. Tradable volatility products can offer some help. Investors are probably familiar with the VIX as a gauge for the volatility expectations of markets, but it is not tradable. In contrast, VIX futures and options, various exchange-traded products (ETPs) linked to implied volatility exposure, and put options are tradable. These products’ greater sensitivity to large downside market movements and less sensitivity to upside market movements make them attractive for hedging tail risk without overly penalizing a portfolio’s upside. The heightened sensitivity of volatility also allows it to be a more efficient diversifier than either fixed income or cash because the same level of risk reduction can be achieved with less capital. The behavior of volatility is marked by the properties of increased correlation during periods of market stress and negative correlation with broad-based equity market indices.
But investors must be careful to match the appropriate method of achieving volatility exposure with their expectations for volatility itself. Known as the cost of rolling futures and futures indices, contango is prevalent when future expectations for volatility are higher than the current volatility and when the futures term structure slopes upward. During periods of heightened market stress, the term structure can become downward sloping when expectations are for declining volatility, leading to backwardation, which can increase returns. Investors must balance the benefits of adding volatility exposure to their portfolio with the costs of maintaining this exposure.
Profit-seeking investors should note that because VIX derivatives are mean reverting, they do not contain a positive risk premium. Thus, assets linked to them may not appreciate over longer periods.
How Did the Author Conduct This Research?
The starting point for the author’s work is an examination of prior research to uncover patterns in volatility that will help support its analysis. One such characteristic is volatility’s negative correlation with the S&P 500 Index, particularly in falling markets. The author examined monthly changes in the S&P 500 versus the VIX from 2006 to 2011 using Bloomberg data to substantiate this pattern.
To gain insight into the market’s view of expected VIX levels for different time periods, the author plots VIX futures contract prices for two dates, one exhibiting contango, or an upward-sloping term structure of implied volatility, and one exhibiting backwardization, when near-term prices are higher than they are expected for distant dates. Contango pricing patterns prevail approximately 70% of the time. This result means that costs are higher for maintaining volatility exposure in contango than in backwardization.
The author next examines specific properties of tradable rolled VIX futures and VIX futures indices over various time periods from 2007 to 2011 to ascertain whether they were consistent with the underlying VIX. Rolled futures indices are rules-based strategies introduced by Standard & Poor’s in early 2009. They incorporate the costs of rolling futures and are weighted to reflect the market’s short-term (one month) and mid-term (five month) forecasts for the S&P 500 VIX Short-Term Futures and S&P 500 VIX Mid-Term Futures indices, respectively. By plotting the S&P 500 versus the VIX and rolled S&P 500 VIX futures, the author is able to confirm their negative correlation supporting the diversification benefits of both the VIX and VIX futures. The beta of the short-term futures index to the VIX is twice as large as the mid-term futures index, which is evidence of its greater sensitivity.
The author then considers investment applications for tradable volatility by examining data for the VIX, VIX futures indices, and the S&P 500 over the period of 2006–2011. From the 10 largest daily and weekly moves, it is apparent that upward moves in the VIX products are higher than the downward moves and that they are negatively correlated with movements in the S&P 500.
By plotting short-term and mid-term rolled futures versus the S&P 500 over the period of 2007–2011, the author assesses tail risk management for exposure to an equity index. The data reinforce the greater sensitivity of VIX futures to larger downside moves in the S&P 500.
Finally, she evaluates asset allocation of VIX products. She finds that adding volatility exposure to a portfolio was not only effective at modifying risk but also much more capital efficient than traditional risk-reducing asset classes, such as fixed income or cash, although the returns for the short-term VIX futures are lower than some asset allocations containing fixed income.
I must confess that I had not previously considered tradable volatility as an asset class, but the evidence presented by the author certainly indicates its flexibility in investment strategies. Although all investors are demanding that risk modification products keep pace with ever more complex investments, I suspect that VIX-based volatility exposure products will be of greater appeal to institutional than retail investors, at least in the short term.