Exchange-traded products (ETPs) offering exposure to equity market volatility have been attracting substantial interest from investors.
According to Morningstar’s asset flow data, volatility-linked products saw EUR 318 million net inflows during 2012. Of this sum, EUR 65 million was invested in the Source JP Morgan Macro Hedge US TR ETF (MHUU) during the final three months of 2012.
What might explain this interest in volatility tracking products? How do these products work? And to what type of investor (and investment purpose) are they best suited?
One of the most appealing attributes of equity market volatility is its high negative correlation to share price performances, i.e. as share prices are falling, volatility measures tend to be rising, and vice versa. This characteristic indicates that volatility might offer substantial benefits as a portfolio hedge, at least in theory. In practice, however, it can be difficult and costly to put this asset class to good use.
In part one of this series, we will explain some of the key concepts investors need to understand about volatility. In part two, we will provide a closer look at the products that offer exposure to volatility.
What Is Volatility?
Volatility has long been a standard risk measure in financial markets. In its purest form, it measures the fluctuation of a financial asset’s rate of return around its mean average. It is crucial to understand that volatility doesn’t measure the direction of price changes but rather their dispersion.
When discussing volatility, investors need to distinguish between historical, forecast and implied volatility. Historical volatility is, as its name suggests, based on historical data and therefore relatively straightforward to compute. Just as past performance is not a reliable predictor of future returns, historical volatility is a poor predictor of future volatility.
Forecast volatility is an attempt to predict future levels of volatility using statistical models based on historical data.
Lastly, implied volatility is derived from option pricing theory and tries to forecast the market’s future volatility based on the current prices of equity options contracts. In other words, implied volatility is the volatility of an underlying security that is implied by the market prices for its listed options based on an option pricing model. Almost every volatility index is constructed using a measure of implied volatility.
Over the last decade, volatility has emerged as an asset class in its own right. The VIX index represents the market’s expectations for stock market volatility over the next 30 days. The VIX usually spikes when share prices plummet and as such is considered a potential diversification tool.
Why Volatility Isn’t that Simple
One of the biggest problems with volatility is that spot volatility indices like the VIX are not investable. As such, investors as well as index and product providers can only achieve volatility exposure via the futures market.
There is a variety of issues related to accessing volatility via futures contracts. Firstly, implied volatility and realised volatility often differ. For instance, the CBOE Volatility Index (VIX) measures the expected 30-day volatility in equity markets, as implied by the various S&P 500 Index options. According to S&P, the level of implied volatility measured by the VIX has exceeded realised volatility over the subsequent month in 86.4% of all months from February 1990 through June 2008. Stated differently, changes in the VIX reflect changes in implied volatility. Changes in VIX futures, and therefore the level of VIX-related indices, reflect changing expectations of implied volatility.
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Another key issue presented by accessing volatility via futures contracts is the matter of cost. VIX indices reflect a strategy of continuously rolling VIX futures contracts. The cost of rolling these contracts has historically had a massively negative impact on these indices’ performance.
What explains this? The VIX futures market is usually in contango. This means that the futures curve for the VIX is typically upward sloping, reflecting the market’s expectation for an increase in equity market volatility. As a result, when futures contracts are rolled forward, the price paid for the new contract is usually more than the price received for the sale of older contracts. Thus the regular rolling of futures contracts forces the index to essentially “sell low” and “buy high”, a losing strategy.
Typically, the benchmark index will see a positive return only if actual increases in the VIX exceed market expectations. That is to say that realised volatility ultimately exceeds implied volatility. All else being equal, the benchmark is likely to have negative performance over the longer term due to the aforementioned contango effect. Furthermore, the longer the maturity of the futures contract, the less sensitive it is to changes in the underlying spot price as seen in the graph below.
It is the periodic rolling forward that contributes to the performance difference between the spot volatility and the volatility futures. According to a study by S&P, the S&P VIX Short-term Futures Index lost an average of 0.18% on a daily basis between December 2005 and August 2011, as a result of rolling futures contracts in order to maintain exposure. By way of comparison, the S&P VIX Mid-Term Futures Index lost only 0.07% on an average day during this time period. As we will see later, these two indices are highly but not perfectly correlated to the spot VIX index as a result of the two phenomena discussed above.
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While volatility is highly negatively correlated to stock prices, the magnitude of the level of correlation is much larger when the stock market plummets than when it shoots higher. Additionally, it is important to note the mean-reverting tendency of volatility. Volatility can drop as quickly as it rises. Also, as noted previously, volatility exposure can cost more during normal market conditions than it might return during adverse conditions (as can be seen in the graph above).
VIX futures contracts are inherently less sensitive to fluctuations in spot VIX; further explaining the divergence between the spot VIX and futures-based VIX indices. The degree of sensitivity declines further out on the futures curve. As such, there is a slightly lower correlation of the S&P 500 VIX Mid Term Futures TR Index relative to the S&P 500 VIX Short Term Futures TR Index, as seen in the next table.
Caveat Emptor
The two most popular indices measuring the expected volatility of the S&P 500 Index are the S&P 500 VIX Short-term Futures Index and the S&P 500 VIX Mid-term Futures Index. The former index measures the return from a rolling long position in the first- and second-month VIX futures contracts, whereas the latter measures the return from a rolling long position in the fourth-, fifth-, sixth- and seventh-month VIX futures contracts. The proportion of the index invested in each futures contract is adjusted daily, so that the indices reflect a constant maturity of one and five months, respectively.
Some assets like commodities and government bonds show very low correlations to equities, but volatility has historically exhibited a strong negative correlation with stock prices. The CBOE’s spot VIX Index showed a level of correlation of -72% with the S&P 500 Index over the past five years. As we showed in the previous graph, the two main VIX futures indices have risen substantially during periods of market stress.
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Unfortunately, as is the case with any form of insurance, there are premiums to pay. As seen in the previous section, volatility indices have shown strong mean-reverting tendencies: during periods of relative calm, volatility hovers at the lower end of its full range; during extreme market dislocations, it will skyrocket. But most of the time it just hovers somewhere in between.
Ultimately, an investment in volatility will not produce any long-term gains because the market does not grow structurally more risky with time. This makes holding a long volatility position a costly proposition for long-term investors.
Conclusion
As volatility is a very sophisticated and potentially costly portfolio tool, it is neither suitable for the long-term investor nor for the less sophisticated one. Therefore only investors who fully comprehend the underlying mechanics should consider volatility-linked products.
In addition, these products are best suited for investors seeking a short-term hedge for their equity portfolio. Investors interested in adding volatility exposure to their portfolios are invited to read our second part of this series, which will explain some of the products offering access to volatility in more detail.
