“If you can’t take a punch, you should play table tennis.” – Pierre Berbizier (1995)
We wrote last week about the dangers of breathing too large a sigh of relief in the wake of Emmanuel Macron’s clearly cathartic victory in the recent French elections. The point being that the visible ‘known’ risks were only ever one small part of that future risk picture. This week, markets were taken by surprise by the gathering momentum behind the, still remote, potential for President Trump to be impeached. If not quite an ‘unknown unknown’, markets were certainly taken by surprise, as demonstrated by sharp falls of higher quality bond yields and the first genuine setback for stocks of the year. Such a backdrop again begs the question of how best to protect ourselves against these future unknowns?
Many have wondered whether the previously low levels of implied volatility reflected by the market’s ‘fear gauge’, the VIX, represented an opportunity in itself? If implied volatility is currently below its historical average, wouldn’t buying volatility itself give us some welcome, and apparently inexpensive, protection from the rough and tumble of the market?
The problem is that the VIX is just an implied measure extracted from a bundle of underlying options, so unlike a traditional equity or bond index, it’s impossible to invest directly in it. The only way to go long volatility is by investing in VIX futures or the exchange traded products (ETP) that are linked to them. However, the fact that the VIX futures market is usually in ‘contango’, with longer term VIX futures more expensive than near-term ones, has made this a very unprofitable investment over time.
Unlike a stock, one cannot hold a futures contract indefinitely since it has an expiry date. Therefore, an ETP wishing to maintain its long exposure to the VIX would have to buy expensive longer dated VIX futures and sell cheaper short-dated VIX futures that are about to expire in its portfolio. By ‘rolling’ from one contract to another, the ETP will be permanently compounding negative returns. For example, the S&P 500 VIX Short-Term Futures Index, which tracks the return of a constant maturity one-month VIX future, is down 99% since 2007, for an annualised return of –44%. Conversely, being short volatility has actually proved lucrative over time, with the S&P 500 VIX Short-Term Inverse Futures Index up by 456% since 2007, providing an annualised return of 19%.
Furthermore, history tells us that a low VIX doesn’t necessarily signal lower equity returns, neither does it signal an impending eruption in market volatility. Typically, a VIX decline below 11, as seen last week, is usually followed by similarly lower volatility over the three month horizon. Meanwhile, past declines of a similar magnitude have usually been followed by positive, rather than negative equity returns over the same timeframe.
The idea that buying volatility or drawdown protection loses money over time shouldn’t be surprising. The textbooks tell us that equities have historically tended to provide higher returns than bonds because investors should be compensated for the extra risk they are taking by investing in the former. Any protection on equity exposure would move that risk onto another investor, who again should be compensated for taking on that risk. Therefore, a long equity strategy with a protective overlay should be expected to underperform the wider equity market over the long term. Reassuringly, in a sense, it has. A strategy that owns the S&P 500 Index, while buying a monthly put option as a hedge, has significantly underperformed the wider market over time. Conversely, selling protection, which plausibly earns you a premium for taking on all the downside risk of the market, has performed just as well as the wider stock market.
If you want to insure your portfolio against drawdown risk, it’s going to cost you. For those who genuinely wish to further protect their portfolio, it may just be easier and cheaper to do so by reducing equity exposure.