A long-sought goal of advisors is a cost-effective way to hedge one’s equity holdings. I previously wrote about why put options fail to achieve this goal. In this article, I consider whether volatility-based products are any better.
My August 22, 2019 article for Advisor Perspectives demonstrated that while put options are rightly viewed as the most direct way to protect against losses in equities, the research shows that they are painfully inefficient, providing “pathetic” protection. For example, it shows:
- Unless option purchases and their maturities are timed just right around equity drawdowns, they may offer little downside protection.
- Portfolios protected with put options have worse peak-to-trough drawdown characteristics per unit of expected return than portfolios that have instead simply statically reduced their equity exposure in order to reduce risk.
- While put protection performs well during crashes it is very costly during the “normal” times which constitute 86% of the sample, and expansionary (non-recession) times, which constitute 93% of the observations.
The research has shown that because protecting with put options has led to a significantly lower Sharpe ratio than divesting, investors who reduce their positions will likely achieve better outcomes than those who purchase protection with puts.
Because there is a well-documented negative correlation between volatility of equity prices and stock returns, buying volatility insurance is another hedging option which investors can consider. Kim Christensen, Charlotte Christiansen, and Anders Posselt contribute to the literature with their September 2019 study “The Economic Value of VIX ETPs” in which they examined investing in portfolios that consist of the benchmark assets (stocks and bonds), and the new VIX exchange-traded products (ETPs) for diversification.
The CBOE Volatility Index (VIX), created by the Chicago Board Options Exchange, is a real-time market index that represents the market's expectation of 30-day forward-looking volatility. Derived from the price inputs of the S&P 500 index options, it provides a measure of market equity risk and investors' sentiments. In 2009, the first exchange traded volatility products, iPath S&P 500 VIX Short-Term Futures Exchange Traded Note (VXX) and S&P 500 VIX Mid-Term Futures Exchange Traded Note (VXZ) were launched by Barclays Capital. Today, 13 VIX ETPs are listed.
The authors begin by noting that volatility exposure diversifies and protects portfolios when it is needed the most. However, this exposure comes at a cost in terms of negative expected returns of long positions in VIX ETPs when volatility is normal. As an example, they noted that Robert Whaley, author of the study “Trading Volatility: At What Cost?” published in the Fall 2013 issue of the Journal of Portfolio Management, found that from December 2005 to March 2012, investors in VIX ETPs (excluding inverse products) lost almost $4 billion. The problem is that the apparent ex-ante benefits have been more than offset by the high roll costs (implied volatility has been greater than realized volatility) for these products.
In their study, the authors examined seven different investment strategies. For each investment strategy, they examined three different portfolios. The first portfolio serves as the benchmark and contains only U.S. stocks and bonds. The second and third portfolios included either a short- or a medium-term VIX ETP. The investors allocated capital between the assets in the portfolios on a monthly basis. Since the study focuses on ETPs, and the first ETPs were issued in 2009, the data set covers the period January 30, 2009 through June 29, 2018.
The authors did note that although their sample was after the financial crisis, it contained several episodes of turbulence such as May 2010 (”flash crash”), June 2010 (Greek debt crisis), August 2011 (S&P downgrade of the US credit rating), August 2015 (Renminbi devaluation), and February 2018 (“volmageddon” – the day the VIX doubled). However, they also simulated data to cover the financial crisis of 2008. The following is a summary of their findings:
- VIX ETPs have very poor average returns which are more negative than reported in previous studies. This is not a surprise as the VIX futures term structure has mainly been in contango.
- For short-sales constrained (long-only) investors, the value of protection during times of market stress is quickly vaporized due to the roll costs associated with the rebalancing strategy of the VIX.
- The standard deviations indicate that the VIX ETPs are far more volatile than both stocks and bonds.
- Except for one period (2009-2010), the economic value of diversifying with VIX ETPs is negative.
- Even accounting for the simulated market crash is not enough for the VIX ETPs to add economic value to the investor.
- An investor who wants to insure against corrections in the equity market faces the trade-off between paying the higher premiums of shorter-dated products and then getting larger payouts in times of market distress versus paying lower premiums but also getting lower potential payouts from the longer-dated products.
They cited the specific example of a long position in one ETP (VXX) which, because of the roll cost, from its inception date until September 14, 2018 would have lost 99.9% of the initial investment. The longer dated product (VXY) would have lost less as roll costs are lower on longer-dated products. The authors concluded that with their return profile, “it seems obvious that these VIX ETPs are not suitable for buy-and-hold strategies which is also stated in their prospectus.” They added that “the negative returns investors in general pay for holding long positions in VIX ETPs, can be viewed as a skewness premium, in order to reduce negative skewness of common portfolio components.” Their conclusion should not be a surprise as investors pay premiums to buy insurance against bad things happening. In this case, they pay what is called a variance risk premium. For those interested in learning more about the VRP, I summarized the research in my Alpha Architect article of August 15, 2019.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.
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