The Missing Link

Most well-read investors are aware of the need to hold both bonds and equities in their portfolio. Even though these instruments often have correlated returns, the diversification benefit and the periodic boost through active rebalancing still mean a stock/bond portfolio is better than stocks alone. “Better” can be measured in many ways but we can keep it simple.

Since June of 2004 (a starting period that will make sense later):
·       A 60/40 mix of equity and bonds had an average annualized return of 10.6% and annualized volatility of 11.0%. Maximum drawdown was 36.8%.

·       The S&P 500 (including dividends) had an average annualized return of 7.6% and annualized volatility of 19.4%. Maximum drawdown was 56.8%.

This is a decisive victory for the idea of a portfolio over just equities. This idea can be extended to other asset classes as well. For example, we could include commodities and real estate.
But in the last few decades several products have been developed that depend in some way on volatility. These have given rise to the concept of volatility as an asset class. Here we will show that a volatility position can improve both the return and Sharpe ratio of a portfolio when compared to one with the traditional mix of stocks and bonds.

The basic idea of volatility is familiar to any investor. Volatility is a measure of the variability of an asset’s returns. It is often used as a measure of risk. Any time we have historical return (or price) data we can estimate what volatility has been. Volatility is defined as the standard deviation of the returns, and the larger this number, the larger the moves of the underlying asset. Volatility varies in time due to the influence of macroeconomic events such as inflation, unemployment and money supply; microstructure effects such as intrinsic crashes and squeezes; and external events such as terrorist attacks, earthquakes and elections. This variability of volatility means there are many nuances in measuring past volatility and even more in forecasting future volatility.

There are two main types of volatility. Realized volatility is the variability of the underlying. Implied volatility is the volatility predicted by an option pricing model. Realized volatility can be traded through variance swaps and volatility swaps but these are not available to most investors. An easier way to trade volatility is through implied volatility.

Implied volatility is option pricing model dependent, but it is possible to use all the option prices for one expiration on a given underlying and recover a model free implied volatility. This is the idea behind the calculation of the VIX index, a model free, 30 day, implied volatility index for the S&P 500.

Implied volatility, whether from options themselves or from the VIX futures, tends to be overpriced relative to subsequent realized volatility. We can see this by comparing the level of the VIX to the subsequent 30 day realized volatility. The average premium since 1990 has been 4.2 volatility points or 23% of the VIX level.
(VIX is in blue).

The easiest way to see why implied volatility would be overpriced is to realize that people buy options as insurance against something that might happen. Puts give protection against price drops and calls protect from the regret of missing a rally. And just as with life and property insurance, people are prepared to pay a premium for this protection. Insurance buyers aren’t being stupid. Their evaluation of their personal exposure to risk makes the purchase sensible, even if it is expected to lose money.

Because implied volatility is usually over-priced we can make money selling it. Unfortunately, it isn’t directly tradeable. There are several ways to get short implied volatility exposure and each has some wrinkles associated with it. One way would be to sell options then dynamically hedge them. While this is a legitimate idea, it is not a pure implied volatility play: there is also exposure to the realized volatility.

We can also choose to sell VIX futures. VIX futures are unusual. Standard economic thinking tells us that a future price should be an unbiased predictor of the underlying price when the contract expires. This is untrue for VIX futures. Instead the futures tend to move towards the VIX index. So, if VIX futures are higher than the index, we can sell them and expect that they will fall. And as the VIX futures usually are higher than the index, we will expect to make money being short VIX futures.
The CBOE publishes a strategy index, VPD, which combines a money market account with short front month VIX futures (details can be found at The exact number of futures corresponding to a given notional investment will vary slightly depending on money market rates but currently one future would be held for each $100,000.

Below we show the performance of VPD since June of 2004 (I said this date would be relevant). Average annualized return has been 18.8% and annualized volatility has been 20.8%.

Even though volatility and equity have negative correlation, the exceptional returns of short volatility mean that the best way to help our portfolio is to replace some long equity with a short volatility position.

Moving just 2.5% of the portfolio from equity to a short position in front month VIX futures led to an average annualized return of 12.3% and annualized volatility of 10.9%. Maximum drawdown was 38.1%. Adding short exposure to the portfolio increases returns and lowers risk, whether we define this in terms of volatility or drawdown.

But we can do much better. As we hinted at when we discussed the general properties of volatility, it is much more predictable than equity prices. Talton uses several models to time the volatility markets and trades a dynamically adjusted option portfolio. This can’t be directly compared to the VPD allocation because the margining is different, so let’s take a concrete example. In 2016, the basic 60/40 portfolio would have returned 8.7% with a volatility of 7.5% and a drawdown of 5.6%. Changing this allocation to 50% equity, 40% bonds and 10% at Talton changes these results to a return of 10.3% with a volatility of 6.6% and a drawdown of 4%.

There are many ways to get a short volatility exposure. You can use strategies involving futures, options and an almost infinite number of combinations of these derivatives. And depending on exactly how you choose to invest in volatility, the amount of your portfolio to commit will be different. But however you choose to get this exposure, you really need short volatility in any portfolio. It is the missing link.

Euan SinclairComment