Volatility as an asset class: Holding VIX in a portfolio

• DOI: http://doi.org/10.1002/fut.22094
• Published date: 01 June 2020
• Author: James S. Doran
• Date: 01 June 2020

J Futures Markets. 2020;40:841–859. wileyonlinelibrary.com/journal/fut © 2020 Wiley Periodicals, Inc.

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841

Received: 12 May 2019

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Accepted: 3 January 2020

DOI: 10.1002/fut.22094

RESEARCH ARTICLE

Volatility as an asset class: Holding VIX in a portfolio

James S. Doran

School of Banking and Finance,

University of New South Wales, Sydney,

New South Wales, Australia

Correspondence

James S. Doran, School of Banking and

Finance, University of New South Wales,

Sydney, NSW 2052, Australia.

Email: j.doran@unsw.edu.au

Abstract

Hedging market downturns without sacrificing upside has long been sought by

investors. If VIX was directly investable, adding it as a hedge to the S&P 500

would result in significantly improved performance over the equity only

portfolio. However, tradable VIX products do not provide the hedge or returns

investors seek over long‐term horizons. Alternatively, deconstructing VIX to

find the key S&P 500 options which drive VIX movements leads to a synthetic

VIX portfolio that provides a more effective hedge. Using these options captures

correlations and returns similar to VIX, and combined with the S&P 500,

outperforms the buy‐and‐hold index portfolio.

KEYWORDS

portfolio returns, S&P 500 index, VIX index, volatility

JEL CLASSIFICATION

G11; G12

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INTRODUCTION

Extreme stock market downturns are the most disconcerting periods for investors since they are risk averse, wish to

limit their exposure to volatility, and seek to avoid negatively skewed payoffs (Kumar, 2009). Significant market

downturns, such as those experienced from October 2007 to March 2009, resulted in massive losses for most investors as

equity indices retreated over 50%. The anxiety of such movements even provoked many investors to sell large portions

of equity, mutual fund, and exchange‐traded fund (ETF) holdings, thus guaranteeing large losses.

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The ability to more

effectively hedge equity investments with assets that would reduce portfolio downside risk and without giving up

upside potential could combat a considerable amount of investor unease.

While several assets exist with returns that are, on average, negatively correlated with equities, these

instruments do not appear to provide the desired hedge againstmarketdownturnssince the return correlations

either become positive in times of distress or are to cost prohibitive. For example, during the market collapse in

2008, the value of both equities and commodities fell, though traditionally, commodities are negative beta assets.

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Bond holdings also declined in value during the 2008 crash, as the risk in commercial borrowing increased while

liquidity fell. Many hedge funds designedtocushionlossesinequitymarkets experienced reversals over the

2007–2009 period. Szado (2009) documents the increased correlation of asset returns over the crisis period above

the levels seen in the 2004–2006 period, implying that as the need for diversification grew, the ability of many assets

to hedge equity holdings shrank at the most inopportune time. Additionally, while tail‐oriented products like long

puts did very well in crash periods, in periods of stability, such as the recent bull market from 2009 to 2018, they

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Mary Pilon, “Many Bought Shares High, Sold Low,”Wall Street Journal, May 18, 2009.

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Numerous commodity indices also retreated by more than 50% of value during the equity market decline of 2007–2009 as inflation ground to a standstill and consumption of raw materials slowed.

have had significant negative performance.

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So, where do investors turn to manage downside risk beyond having

perfectmarketforesight?

Holding volatility would appear to be the answer. If a portfolio could hold volatility as an asset it may make

traditional negative or counter‐cyclical investments moot for hedging purposes. This is because of the mean‐reverting

nature of volatility and its negatively skewed payoff. Thus, investors’interest in the VIX index.

Since the introduction of VIX, it has widely been regarded as the economy’s indicator of risk in the equities market.

As noted by Whaley (1993, 2000), the VIX index is considered “the investors’fear gauge index.”An important

byproduct of introducing VIX was the newfound opportunity for investors to trade in futures, introduced in March

2004, and options, introduced in February 2006, thus allowing investors to enter into contracts which generate payoffs

specifically related to volatility. Additionally, exchange‐traded products have been established, starting in 2009 with the

iPath S&P 500 VIX Short‐Term Futures ETN (ticker: VXX, SVXY, and others), that offer a more direct way to access

volatility as an investment. While it is possible to invest in equity options on the S&P 500 and construct a payoff that

would be related to the volatility of the index, these VIX products provide a simple, but not necessarily effective, way to

invest in VIX that is attractive for investors looking to hold or sell volatility.

A number of researchers have considered the possibility of hedging portfolios with VIX‐mimicking assets. Dash and Moran

(2005) initially considered the ability of newly formed VIX‐based products to lower portfolio risk. Emerging possibilities then

developed for such a strategy, including the use of VIX futures, VIX options, and VIX‐based ETNs. Brenner, Ou, and Zhang

(2006) introduced an option straddle specifically designed to hedge volatility risk. This instrument is sensitive to volatility

innovations and thus useful as a hedge. Windcliff, Forsyth, and Vetzal (2006) consider the variations in the contract designs of

volatility derivatives and discuss the difficulties of hedging the returns with such instruments, particularly given delta and delta‐

gamma hedging techniques. Black (2006) and Moran and Dash (2007) find that adding VIX futures to a passive portfolio can

significantly reduce portfolio volatility. VIX’s quick movements during risky markets also improve the skewness and kurtosis of

the overall portfolios. Briere, Burgues, and Signora (2010) advocate a sliding approach when hedging in which more (fewer)

VIX futures contracts are held when VIX levels are notably lower (higher) due to the mean‐reverting nature of the index. Jones

(2011) and Warren (2012) also advocate using VIX futures only in a tactical manner.

However, it does not appear using these products provides a payoff like that of the VIX index or provides the long‐

term hedge against increases in volatility that most investors desire. As Szado (2009) notes, exposure to VIX calls and

puts, as well as VIX futures, does not directly mimic holdings in the spot levels of VIX given that the mean‐reverting

nature of the underlying are priced into the derivative values. While H.‐C. Chen, Chung, and Ho (2011) suggest VIX

futures do enhance the performance of a portfolio of equities, Whaley (2013) points out that trading VIX products result

in poor performance. More recently Basta and Molnar (2019) and Bordonado, Molnár, and Samdal (2017) address the

ineffectiveness of using VIX and VIX‐style products as hedging or speculative strategy.

Given the current evidence that VIX products are not effective hedges leads to a basic question; since VIX is

constructed using tradeable assets, should it not be possible to create a portfolio that uses these underlying assets as a

hedge in a more effective and profitable way than the current traded products?

To answer this question three steps are taken. First, a portfolio is constructed that holds VIX and the S&P 500,

treating VIX as a tradable asset. The returns to this portfolio will reveal whether “investing”in the cash VIX index

provides a more effective hedge to long‐equity positions, either through lower costs or superior returns, than alternative

hedges, such as purchasing index puts. This seems especially relevant given the current low levels of volatility and

steepness of the volatility skew. The results show that, if the VIX index were directly investable, holding VIX in a

portfolio with the S&P 500 yields positive and significant alphas across all market cycles, and are in direct contrast to

the evidence for the tradable VIX assets. VIX futures, ETNs, or single use options do not replicate or provide the hedge

that trading the cash VIX index would even when accounting for the level of volatility.

Second, a test to determine the S&P 500 options that drive the changes in VIX is conducted. This test goes beyond

Whaley (2009), who sought to clarify the meaning of VIX and discuss its characteristics. Whaley emphasizes that, like

the S&P 500 index, the VIX index is not directly investable. While it is quite simple to replicate the payoff of the S&P 500

by holding the 500 underlying stocks in the appropriate proportions (or more simply, via investment in low‐cost ETFs),

it is difficult or nearly impossible to replicate VIX by holding the underlying S&P 500 options. This is in part because

VIX is constructed using call and put out‐of‐the money options with two maturities closest to 30 days, with weights that

are squared. Additionally, these weights change daily. Thus, even if a portfolio were able to hold the correct proportions

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Refer to the performance on a put writing strategy by the Asset Consulting Group that noted total return for put writing strategy is 1,153% since 1986. This is also consistent with the findings of

Ilmanen (2012) and Litterman (2011).

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DORAN