By Theo Casey, a columnist at Futures & Options World, blogging live from FOW’s European Equity Options conference in Amsterdam.
(*With apologies to Dizzee Rascal.)
Later today, I will be serving as moderator of a discussion panel on trading volatility. One of the questions I will put to my panellists is – and perhaps at this point it is rhetorical – is volatility an asset class?
I say rhetorical because, with 788,908 VIX futures and 7,046,691 VIX options traded in February, both all-time records, volatility is already an entrenched part of the global investment conversation. From CNBC and Bloomberg News to the broadsheet press, reference to the CBOE’s VIX as the market’s fear barometer is increasingly commonplace.
And Barclays’ VXX exchange-traded note – with $1.6bn of client money trading “long vol” – is often interpreted as the simplest tradable proxy for that fear.
Except that it’s not.
Or maybe it is.
It’s all a bit unclear, to be honest.
What we do know is that the VIX, the spot index, is untradeable. Why? It’s too dear to replicate.
Take this from Jeremy Wien, Head of VIX Trading at Peak 6 Capital Management:
“While the VIX can be a great tool, and the VIX tradables (like futures and options) are quite liquid to trade, the spot VIX itself cannot be realistically replicated, as the execution/bid-offer costs are too high, and rolling the two strips every single day would be a logistical nightmare.”
Options are not as liquid as are shares, execution not universally as affordable and the unintended consequences of rolling “the two strips” – the assortment of options, long and short, that create the spot price of the VIX – might engender a volatility of its own.
So the VXX is thusly the next best thing. Its modus operandi is simply in holding short-dated VIX futures. These futures exist in a steep contango between the front two months. This is not news to market locals. Indeed, the heavy roll costs have been well documented both in the pages of FOW and here on FT Alphaville.
UBS’ Michael de Vegvar recently detailed just how punishing that roll cost can be, expressing that the strategy currently costs circa 10 per cent a month.
Why is it, then, that this message doesn’t appear to have reached those people who anointed volatility as an asset class in the first instance?
In 2003, Goldman Sachs’ Emanuel Derman put forward the case of volatility as an asset class with scant reference to the dangers of a fierce contango.
In 2004, Keith Black — named on Institutional Investor magazine’s list of “Rising Stars of Hedge Funds” in 2010 – wrote a widely cited paper titled “How the VIX ate my kurtosis” showing spot VIX and how the incorporation of the VIX in an equity portfolio smoothens the returns and boosts the Sharpe ratio of risk-adjusted returns.
This is colloquially understood as the VIX® – like good bacteria – ‘eating the kurtosis’, suppressing overall negative portfolio results.
This is a move borrowed by CBOE, who in their research paper “Using VIX in a Diversified Portfolio” show how Sharpe ratios improve incorporating, presumably spot VIX, into the asset allocation.
Alas – if we use VXX as a proxy, the two year track record of the tradable fear shows it chewing on kurtosis but ultimately throwing it back up again. The VXX is down 30 per cent more than the reference index since inception.
So while these theoretical arguments are sound, the trumpeted benefits to the Sharpe ratio are unfounded using real world proxies.
As such, it’s difficult to consider VIX futures as engendering the long-term buy and hold investor you’d normally associate with a conventional asset class. This is a tool primarily for short-term traders.
It also highlights the importance for investor education in this market – narrative-driven retail investors that might not appreciate the nuance of investing through futures have learned the hard way what effect roll yield has on returns. Susan Milligan at the OCC is acutely aware of the need for this education:
Educating retail investors on all aspects of trading listed options is an integral part of our mission. That education includes helping them to assess volatility as they design a trading strategy. This is especially important in markets, like the US, with a great deal of retail participation.
Most interestingly, the state of the term structure creates an opportunity for future innovations.
The VIX is a unique and popular index. Futures and options tied to it provide an asymmetric payoff that runs counter to the performance of equities. If someone could harness that power, while reducing the effect of the contango, then investors might be able to hedge themselves more passively against market corrections.
I’ll be speaking with just such the person later today. Watch this space.