Are VIX ETPs Effective at Protecting Downside Risk?
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.