The recent correction in the stock market, the conclusion of the Fed’s third round of quantitative easing and speculation about interest-rate increases have understandably reignited investor concerns about volatility. However, while market conditions have become stormier of late, investors and their financial advisors do not need to fear this development—the best way to protect their portfolios is to embrace volatility by investing in mutual funds or exchange-traded funds that capitalize on market movement.
Allocating a small portion of an investment portfolio to volatility funds may hedge downside risk not only for equity investments, but across other asset classes as well. Increases in volatility rarely confine themselves to a single asset class—they usually start in one and bleed into others. Investors and advisors should think of volatility funds as insurance policies for portfolios—they create an additional layer of protection by quickly offsetting potential losses from other investments, and the returns they generate during market sell-offs can be reinvested in promising assets that become undervalued during the investor rush to divest.
Tracking the ‘Fear Index’
The Chicago Board Options Exchange’s CBOE Volatility Index (VIX) is a well-known measurement of volatility and prognosticator of equity market corrections. The VIX measures the implied volatility (market expectations of price movements within 30 days) of the S&P 500 Index, and is often referred to as the “fear index.” Since implied volatility generally increases in bear markets and decreases in bull markets, the perceived risk of an equity market correction rises when the VIX goes up.
The VIX often moves in the opposite direction of the S&P 500, but while this low correlation between volatility and equities is a diversification benefit in and of itself, it is distinct from the low correlations between equities and other asset classes. Historically, equities’ low correlations to other asset classes rapidly increase (all asset classes sell off in unison) during stressful market conditions—just when investors need them to stay low. However, the correlation between equities and volatility usually decreases during periods of market stress. This means that, unlike other potential hedges, volatility exposure can give equity investors the protection they need when they need it most.
Not all VIX Funds are Created Equal
In recent years, fund managers have launched liquid alternative funds (’40 Act funds with alternative investment strategies historically only available through hedge funds) designed to give investors exposure to volatility. These funds typically invest in a combination of long and short S&P 500 futures and options contracts that trade on the VIX, and attempt to capture both upside and downside movements along the VIX futures curve. Some of the funds invest in stocks of S&P 500 companies in addition to VIX-traded futures and options contracts, enabling investors to benefit from positive equity performance while generating extra alpha in down markets.
These types of strategies are viable options for obtaining volatility exposure, but investors and advisors need to remember that, depending on the portfolio managers, some strategies are more advanced—and offer better protection—than others. Some volatility investment funds simply take positions in VIX futures and passively watch the VIX futures curve.
Passive strategies typically sell 1/20 of the front-month future and buy 1/20 of the second-month future on a daily basis. When the VIX futures curve is in contango (a situation where the front month is less expensive than the second month, and the second month is less expensive than the third month), this daily routine of proportionally selling at a lower price and proportionally buying at a higher price creates decay, which is better known as “drag” in the investment advisory world and can hurt investors.
Other funds attempt to offer more protection by using market-timing strategies that predict when equity investors will most likely need exposure to volatility. While market-timing strategies are certainly an improvement over passive reliance on the VIX futures curve, they can hurt investors if their predictions are wrong or mistimed. If a portfolio manager reduces volatility exposure when his model deems a downturn is unlikely, and the equity market suddenly dips sharply, then investors can find themselves without protection at a time when they are most vulnerable.
When evaluating volatility funds, investors and advisors should look for portfolio managers that seek to identify the most efficient long-term volatility exposure. For example, managers that calculate the relative value of VIX-traded futures and options contracts on a daily basis have a much better chance of finding the most promising investment opportunities over short-, medium- and long-term horizons.
Besides daily rebalancing, portfolio managers that opportunistically short overpriced securities can also help investors create the most efficient exposure to volatility. By shorting overpriced VIX-traded futures and options contracts, managers can recapture the potential decay of long positions on other VIX securities.
Good Insurance Policy
Volatility exposure in an investment portfolio is similar to an insurance policy—it costs money and you hope you never need it, but if you do, the payout will help you pick up the pieces after an unexpected event. The critical component now left to advisors is to appropriately select the most cost-efficient “insurance policy” offering maximum coverage. This new approach to portfolio protection differs vastly from the Modern Portfolio Theory approach of simply having bonds offset stocks during times of distress, but it nevertheless enables investors to protect their portfolios in down markets without hindering them during low-volatility environments.
Jeff Kilburg is Founder and CEO of KKM Financial (www.kkmfinancial.com), an alternative asset management firm specializing in liquid alternative investments.