Making Volatility Investable

Stuart Barton I June 1, 2017

Summary

  • Inverse VIX ETPs have performed extremely well so far this year.

  • Buying and holding inverse VIX ETPs could be a risky strategy in a low VIX environment.

  • Active strategies managing drawdown risk may make these ETPs more investable.

  • In this article I highlight a new way to invest in volatility.

With some inverse VIX Exchange Traded Products (ETPs) gaining more than 80% in 2016, interest in VIX linked investing is perhaps unsurprisingly growing quickly. At the time of writing this article (May 25, 2017), the popular VelocityShares Daily Inverse VIX Short-Term ETN (NASDAQ:XIV) was up more than 60% since the start of the year.

Of course, with these kinds of returns usually comes substantial risk, and continued profit from a passively managed exchange traded product like the XIV relies on recent market conditions persisting - that is to say, the continuation of steadily rallying equity markets and low implied and realized volatility.

But what if these conditions don't persist, what then? Well, as market volatility rises, these passively managed inverse VIX ETPs are likely to lose considerable value, possibly retracing this year's gains - or worse! For example, a 50% single day increase in the value of an inverse VIX ETP's portfolio - say a jump from a value of 12 to 18 in the VIX futures - would likely half the value of the ETP, and put a significant dent in any accumulated gains. Even worse, a single day jump of 100% in the ETP's portfolio - say an increase in futures prices from 12 to 24 - would wipe out the inverse ETPs altogether. This is why few would ever recommend an inverse VIX ETP as a sensible 'buy and hold' investment.

To be fair the sponsors of inverse VIX products disclose this fact quite explicitly in their prospectuses. VelocityShares, for example, points out at the top of page 16 of the XIV prospectus that 'The long term expected value of your ETNs is zero. If you hold your ETNs as a long term investment, it is likely that you will lose all or a substantial portion of your investment.'[1] An ominous warning indeed.

So if one was considering investing in an inverse volatility product, how can some of this risk be mitigated? Well, some have argued that a small permanent holding of maybe 5-10% of a portfolio could allow investors to access the ETP's returns without putting too much capital at risk.[2] Tony Cooper for example, in his seminal paper on the topic proposed a portfolio of 55% equities, 35% bonds, and 10% volatility products to help boost performance while managing the scale of any potential drawdown from the volatility component. He went on to point out that the 'more aggressive equity investors may wish to increase the volatility proportion even higher.'[3]

But Cooper also points out four competing approaches that he believes might outperform this passive 'buy and hold' of inverse volatility products - strategies he categorizes as 'Momentum', 'Roll Yield', 'Volatility Risk Premium', and 'Hedged'. While I won't go into the details of Cooper's strategies, I do encourage you to read his paper and I have included a link to it in this article's footnotes.

And this brings me to the main point of this article. If VIX ETPs are to form part of a longer term investment strategy, how is an investor to act in light of warnings like that posited by VelocityShares above? One way is to follow Cooper's advice and implement one of his proposed active strategies by buying and selling the ETPs at opportune moments. This of course makes sense - selling an inverse VIX ETP before a significant market drawdown and then buying it back days later would improve returns and potentially limit some of the inherent risk.

But managing these strategies can be complicated and time consuming. Backtests of Cooper's 'Hedged' strategy for example required trades every single day, and the time commitment needed to consistently implement that type of trading is probably well beyond most investor's capability.

So how can the average investor access active strategies that look to benefit from inverse VIX ETPs? One way could be to buy trading signals from one of the leading volatility strategists and implement their proprietary approach to maximizing long term gains by attempting to avoid large drawdowns. But again, this works well for active traders but the day to day trading needed to implement the strategies is probably too time consuming for the average investor. Furthermore, with so many strategists offering so many different strategies, how can the average investor be sure they'll be in the best hands?

Another approach is to open an account with a Registered Investment Advisor (RIA) that specializes in VIX products and let them manage a strategy for you. Invest In Vol is the first volatility focused RIA to offer multi-strategist accounts from the three leading volatility strategists. Because no two volatility strategies are the same, diversification across three strategies could improve risk adjusted returns, mitigate drawdowns, and avoid single strategist risk. Furthermore, implementation of a balanced volatility strategy by a specialist RIA in a Separately Managed Account (SMA) turns a time consuming trading strategy into a long term investment, allowing the average investor to finally benefit from the potential diversification of volatility as an investable asset.


This article was originally published on Seeking Alpha. For more Seeking Alpha articles by Stuart click here.

[1] VelocityShares (2016) Prospectus. August 9, 2016

[2] Cooper, T. (2013) Easy Volatility Investing. SSRN.

[3] Ibid, pg. 28.

Disclosure

Investing involves risk, including the possible loss of principal. Carefully consider the Strategy's investment objectives, risk factors, charges and expenses before investing. This Strategy is actively managed and there is no guarantee investments selected and strategies employed will achieve the intended results. Strategy is subject to change. Hypothetical and backtested returns are not actual results based on actual trading of real client funds. Active management may also increase transaction costs. The Strategy is not diversified, and narrowly focused investments may be subject to higher risk. Past performance does not guarantee future results.


This information has been provided by Invest In Vol. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This is not to be construed as an offer to buy or sell any financial instruments and should not be relied upon as the sole factor in an investment-making decision. References to specific securities and their issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. The views and opinions expressed are those of the portfolio manager at the time of publication and are subject to change. There is no guarantee that these views will come to pass. As with all investments there are associated inherent risks. Please obtain and review all financial material carefully before investing. Investments are subject to change without notice.


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Investing involves risk, including the possible loss of principal and fluctuation of value. Past performance is no guarantee of future results. Carefully consider the investment objectives, risk factors, charges and expenses before investing. Invest In Vol, LLC is the investment advisor for the separately managed accounts (SMAs) and advisory services; it provides investment advisory services to clients and does not sell securities. For a more complete disclosure & definitions click here. For a more complete description of our business, Form ADV 2A, and accompanying brochures, click here.

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