Investors often hear of the term volatility as a measure of fear, risk, or uncertainty in the market. But did you know that volatility is also an asset class you can trade and add to your portfolio? This idea is not new as exchange traded volatility products have been around for a long time. With prudent use, a calibrated exposure to volatility can provide invaluable benefits. It not only offers an opportunity to generate returns, but it can also reduce portfolio drawdowns and act as a hedge during turbulent markets.
Let’s delve deeper into this unique asset class.
1. What is Volatility?
Volatility is a measure of the magnitude of price moves in the market. You can think of them as waves in the ocean – sometimes calm and steady, and other times huge and violent. When volatility is high, the price swings in the market are wider and can move quickly within a short time. On the other hand, when volatility is low, prices are more stable and don’t change much day to day.
High volatility is associated with a higher level of fear, risk, and uncertainty often accentuated during episodes of market panic.
Low volatility, in contrast, suggests calm, stability, and a lower level of risk.
In the market, you will also hear about two different types of volatility – realized volatility and implied volatility. They are related yet distinct from each other.
Realized volatility, also known as historical volatility, measures the actual price swings in the past. It is calculated using historical price data.
Implied volatility, also known as expected volatility, looks ahead and tells us how much investors or traders expect the price to swing in the future. It is extracted from option prices as traders embed their expectations of volatility into the price of the options they trade.
Volatility has moved beyond being just a statistical measure or a component in option pricing. Today, there are tradable volatility securities in the market based on the US VIX index and these products are accessible to retail investors.
2. What is the US VIX index and its distinctive characteristics?
Most exchange-traded volatility instruments are based on the popular US VIX index which is also known as the "fear gauge”. VIX is not like your regular stock or bond index which represents a basket of stocks or bonds. Instead, VIX measures how much the market expects the S&P 500 to move against its average over the next 30 days. In more technical terms, it represents the S&P 500’s 30-day expected volatility. This value is extracted from the prices of S&P 500 options.
VIX has two unique characteristics that set it apart from traditional assets such as stocks:
VIX typically moves inversely to the S&P 500
During periods of crisis when the stock market falls, VIX tends to surge sharply as fear and uncertainty spike (see a plot of the VIX Index since 2007 below). And when the market calms, it subsides. These characteristics would make it an effective tool for managing risks in a traditional portfolio.
VIX is mean reverting while stocks tend to trend
To mean revert means that it tends to move back toward its average. We can observe that from the movements in the VIX index over time. It behaves much like a rubber band. Why does that happen? It is not hard to understand this if we think of volatility as a reflection of the market’s mood. It moves up and down according to market events, news, policy changes, etc. Any extreme sentiments, such as panic during a crisis or euphoria in an excessive rally, tend to be transient. As the market digests the information and adjusts, these intense emotions and uncertainty subside and volatility naturally goes back towards its normal range.
3. What are the exchange-traded VIX-based products accessible by retail investors?
The U.S. financial market stands out as the only one offering highly liquid volatility products including exchange-traded funds and notes (ETFs and ETNs). There are both long (profit on rising volatility) and short (profit on declining volatility) volatility products, providing investors the flexibility to speculate on volatility trends, or to use them as hedging tools. Some of the more popular exchange-traded volatility products include the following:
Long Volatility Products
iPath Series B S&P 500 VIX Short-Term Futures ETN (Ticker: VXX)
ProShares VIX Short-Term Futures ETF (Ticker: VIXY)
Short Volatility Exposure
ProShares Short VIX Short-Term Futures ETF (Ticker: SVXY)
-1x Short VIX Futures ETF (Ticker: SVIX)
4. Are there any differences between the VIX index and VIX-based ETFs?
Yes, they do have a few fundamental differences.
The VIX is an index and cannot be traded directly.
Similar to other indices such as the S&P 500 or the NASDAQ 100, the VIX is an index and is not tradable. To gain exposure to indices such as S&P 500 or NASDAQ 100, you need to invest in products such as ETFs that are created to replicate these indices e.g. the SPDR S&P 500 ETF (SPY) or the Invesco QQQ Trust (QQQ). The same goes for the VIX index, you can only access it through volatility products such as the volatility ETFs.
The volatility ETFs do not track the VIX directly
To replicate VIX’s behavior, the volatility ETFs rely on derivatives, such as VIX futures, and follow a related index called the VIX Short-Term Futures Index instead. Thus, their day-to-day movements may not mirror the VIX exactly. Nevertheless, they are still highly correlated in terms of direction.
Long volatility ETFs tend to move in the same direction as VIX on a daily basis more than 80% of the time.
Short volatility ETF, on the other hand, moves in the opposite direction more than 80% of the time.
That is why these products remain a powerful choice for those looking to navigate or hedge against market volatility.
Long-volatility ETFs tend to decay over the long term
Unlike the VIX index which tends to mean revert around its average, long volatility ETFs such as VXX or VIXY experience a long-term decay in their value because they are tied to the futures market. You can see from the chart below that shows the NAV of VXX. Except for the occasional surge due to market panic episodes, its overall price trend is down.
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A slightly technical note: Why do long volatility ETFs decay over the long term?
To understand more about why this happens, we need to talk a little about VIX futures and how these ETFs are constructed.
Contango: An upward-sloping futures pricing and its implications for VIX-based products
VIX futures are exchange-traded contracts that have monthly expiries. Each futures contract reflects what investors expects the VIX level to be at the point when it expires. Under typical circumstances, the further out the expiries, the more highly priced the VIX futures contract will be. Because the further into the future you go, the more uncertain it gets. This increased uncertainty is priced in. If you plot the prices of the VIX index and its futures against their expiries, you will notice them rising as expiry extends. This financial phenomenon or structure is also known as contango.
A contango structure has significant implications for the pricing of volatility ETFs. Because these ETFs typically hold a basket comprising the front month (nearest expiry) and second month (next expiry) futures contracts. The proportion between these two contracts is rebalanced daily to maintain an exposure that always represents the expected level of the VIX index one month into the future.
With VIX futures being in a contango structure most of the time, the value of this basket will erode progressively. Just imagine a theoretical scenario where everything stays the same in the market. As time passes, you will see the value of the futures contracts held in the basket converging lower toward the level of the VIX index. That is why the prices of long volatility products such as VXX or VIXY trend down over time.
Backwardation: A downward-sloping futures pricing or the opposite of contango
During periods of market turmoil, this contango structure can be broken. Amid financial or economic distress, the prices of VIX futures are expected to rise across all expiries. But the spot VIX (VIX index) and near-term VIX futures will increase significantly more than far-dated ones reflecting near-term heightened uncertainty about the market. This will result in a downward-sloping futures pricing structure, the opposite of contango, also known as backwardation. This works in favor of long-volatility ETFs and to the detriment of short-volatility ETFs. Backwardation, however, tends to be short-lived as it typically occurs in times of stress or panic.
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Short-volatility ETFs tend to appreciate over the long term.
Short-volatility ETFs behave in the reverse way. Over time, they tend to appreciate. Because the structural decay that works against long-volatility ETFs benefits short-volatility products which are taking the opposite side of the trade. You can observe this with ETFs such as SVIX and SVXY.
5. What potential benefits do volatility ETFs bring to a traditional portfolio?
Long volatility ETFs - risk management and hedging
Long-volatility ETFs, such as VXX, are designed to benefit from rising market volatility, which typically spikes during periods of market distress. These ETFs tend to perform inversely to the S&P 500, making them effective tools for hedging against market declines.
Inverse relationship between the S&P 500 and long volatility ETFs
In general, the worse the S&P 500 performs, the higher the probability that long volatility ETFs will deliver a positive return—and the greater the magnitude of that return. Below is a table illustrating how VXX performed on days where the S&P 500 posted a negative return from 2011 to 2024. It is clearly evident that a stronger selloff in the S&P 500 corresponds to a sharper rise in VXX, in line with its expected behavior.
The high payoff in a black swan or extreme scenario
Long volatility ETFs have enormous appreciation potential during market black swans or crises. In such scenarios, even a small allocation to these ETFs can significantly cushion against stock market losses and at times even exceed the shortfalls incurred. The table below highlights a few notable episodes where VXX experienced substantial gains. This underscores the potential value of long-volatility ETFs as a hedge against catastrophic events.
Short volatility ETFs - Enhance portfolio return by capitalizing on the volatility decay
Short Volatility ETFs like SVXY or SVIX benefit from declining volatility. Besides that, it also rides on the structural decay in VIX futures caused by the contango pricing structure. As mentioned earlier, contango leads to long-term value erosion in long-volatility ETFs, and short-volatility ETFs gain from being on the opposite side of this trade. Thus, over the long term, these short-volatility ETFs tend to appreciate, making them an attractive option for investors seeking additional returns in calmer or bullish market conditions.
A positive relationship between the S&P 500 and short volatility ETFs
Using SVXY from 2011 to 2024 as an example, we can observe that on days when the S&P 500 post positive returns, SVXY is likely to rise. A stronger S&P 500 rally also tends to result in a bigger upward move on SVXY as well.
Potentially stronger performance than the S&P 500
Within the history of short volatility, there is one catastrophic event called Volmageddon which severely mars its performance. We will talk about this risk later. But if we take the period before and after Volmageddon to compare, short volatility ETFs delivered a performance that beats even the S&P 500. You might note a dramatic drop in the performance of SVXY post-Volmageddon and that is mainly because the issuer had halved the risk of the ETF following the event.
6. What are the risks of investing in volatility ETFs?
Despite its appealing characteristics and uses, volatility ETFs do come with its own risk which arise from their unique behavior. It is important to understand these risks when devising strategies around these ETFs before they are incorporated into the portfolio.
Volatility is, as the name suggests, a volatile asset class
This should not come as a surprise with volatility often being regarded as a reflection of market sentiments. It is a sensitive asset class that can swing dramatically in a short period of time. In the extreme, its range of daily moves and annualized volatility are much bigger than that of the S&P 500.
Long volatility ETFs lose value over time
While long volatility ETFs have the capability to rise substantially in a crisis, they lose value, albeit in a more gradual and steady manner, in the long run. This is because they rely on VIX futures which is priced in a contango structure most of the time. This causes their prices to decline and converge towards the level of the VIX index as time progresses.
On those infrequent occasions where the market experiences stress, VXX can bag windfall profits. But these periods tend to be short-lived as volatility subsides. Most of the time, it is in a state of slow bleeding and loses value. You can observe from the table that it delivers much more on its best days than on its worst but over the long term, its daily average return is negative. Hence, this makes holding long volatility ETFs for an extended period a costly option as this will impose a persistent drag, which can weigh heavily on the portfolio returns.
Short-volatility ETFs are especially vulnerable to sudden crisis
Short-volatility ETFs behave in the reverse manner when compared to their long-volatility counterparts. Over the long run, they appreciate as they are able to ride on the tailwinds of the VIX futures contango structure which works to their advantage. However, they are particularly susceptible to steep losses when catastrophic events hit. These sharp reversals can happen with little warning, posing significant downside risks for investors. The event, also known as Volmageddon in February 2018, is the worst that has happened in history within the short volatility space. This brief episode saw the demise of one of the largest short volatility products (Ticker: XIV) at that time. It also led to the deleveraging of SVXY where the issuer halved its risks.
7. How can the risks of these volatility ETFs be mitigated?
Volatility ETFs are not suitable candidates for passive buy and hold, unlike other traditional asset classes like stocks and bonds. To harness them to our advantage, we would need a more elaborate strategy to actively manage the risks mentioned so that they can be mitigated. These are some of the ways to do it.
Diversify the risk - use volatility ETFs to complement your portfolio
Diversification remains the first line of defense. Every asset class or strategy comes with its own strengths and weaknesses. When carefully selected and calibrated, they can significantly improve the performance profile of your portfolio. So, volatility ETFs should be considered as part of a broader portfolio whether you are looking to boost your returns or using it as a hedge against market downturns.
Limit the position size of the volatility ETFs
It might be tempting to allocate heavily to volatility ETFs given its potential to be highly lucrative. However, this can expose you to potential black swans that can wipe out a huge chunk of your invested wealth. Even if the probability of that happening is small, we wouldn’t want to be in a situation where we are looking at “irreversible” damage. So, limiting the size of the volatility ETFs, for example to less than 10% on initial allocation, is a sensible thing to do. You do not need a large volatility position to make a meaningful impact on your portfolio.
Tactically deploy these ETFs only when conditions are in favor
There are times for long volatility, times for short volatility, and times to do neither and just hold on to cash. A criterion, but not the only one, is much like how one assesses stocks, to see whether volatility is overpriced or underpriced. One way to assess that is to compare the implied volatility (what the market expects) against the realized volatility (what actually happened).
When the implied volatility is higher than realized volatility, the market is “cautious” and overpricing risk. So, theoretically, there is a premium to be made by shorting volatility. When it is the other way around, then the market is “complacent” and underestimating volatility. In this instance, there is a higher probability of events triggering market shocks. In general, when the market is in a complacent state or risk is underpriced, you want to be positioned on the long side of volatility and when the market is in a cautious state or risk is overpriced, you want to be positioned on the short side. And in situations where things aren’t clear, stay out.
Conclusion
Volatility is not just a measure of fear. It is also a valuable and versatile tool that can strengthen the resilience of your portfolio. With the appropriate strategy, it can act as a hedge during harsh market conditions to reduce losses. It can also generate another return stream for your portfolio. However, they are not without risks. To maximize their benefits, we need to manage their downsides through diversification, and position sizing, and tactically deploy them only when conditions are favorable. With the right approach, volatility can be both a sword and a shield.
Disclaimer:
The information provided in this blog post is for educational and informational purposes only and should not be construed as financial or investment advice. The strategies and examples discussed are based on past market conditions and may not be suitable for all investors. In preparing this note or post, we have relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources or which was otherwise reviewed by us. While the information provided herein is believed to be reliable, AllQuant makes no representation or warranty whether expressed or implied, and accepts no responsibility for its completeness, accuracy, or reliability. Investing involves risks, including the potential loss of principal. The performance of any investment strategy is not guaranteed, and past performance is not indicative of future results. Always consult with a qualified financial advisor or professional before making any investment decisions. AllQuant is not responsible for any financial losses that may arise from the implementation of strategies or ideas discussed in this post.
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