The VIX Mirage and the Portfolio Insurance Paradox


Written by Ayman Ismail Abdel Hamid, CFA

At the advent of 29 of January, we woke up to a major selloff on Wall Street. The selloff — or the loss streak, as we call it on the street — went on until 8 February, with the market losing more than $1 trillion in value and the S&P plummeting 9.6%. What happened?

We can write at least ten volumes on reasons behind the selloff, ranging from strong reported wage growth, expectations for above-average inflation, and concerns that the Fed would speed up its planned interest rate hikes. Later in February, when most of these expectations turned out to be true, the market rebounded and the indices started to rise again.

This behavior may make you wonder: Why there was a fear-driven selloff ahead of these expectations, but when they came to pass, the market went up?

The essence of volatility and its reasons

In the current environment, increased correlation between markets and assets mean that bad news in China can cause a major selloff in markets as distant as Wall Street and Europe. The old feeling that investors didn’t need to worry about what was happening outside of their market no longer holds.

This new reality prevents asset managers, wealth mangers, investors, and me from sleeping at night — and it is not an overreaction.

We have come to accept that there is “negative skewness” when equity markets react to news around the world. These days, there is a higher probability that you’ll hear bad news. And since bad news travels fast when it comes to markets, many investors have become focused on a new term: portfolio insurance, an attempt to protect portfolios during loss streaks.

The reasons for streaks and losses in the markets can vary, but high volatility is always lurking in the background. Most asset managers understand that trying to hedge investments against every potential risk can quickly become an expensive drag on performance. But the market is becoming faster, and more unpredictable, and a larger range of events can exert substantial downside effects on the markets.

If you look at the performance of the S&P 500 from the summer of 2014 through February 2018, it looks like this:

July 2014–July 2015: One major downside movement
July 2015–July 2016: 3 major downside movements
July 2016–July 2017: 1 major downside movement
Feb 2018: 1 major downside movement

There is no pattern for these downside movements, or dips. After the three dips that took place from summer 2015 to summer 2016, many expected that 2017 would be a “sideways” year for the market at best. In the end, it was a bullish year. Only one dip took place from summer 2016 to summer 2017, and it was somehow not so steep. Of course, at the start of the 2018, things went south in February.

Can you detect a pattern? I can’t. We can’t say that the rate of downside movements is increasing — if we had another two downside movements in 2018, then there may be a pattern of 1, 3, 1, 3. If we don’t have another downside movement in 2018, then we can say we have a pattern of 1 downside movement per year on average, and we can consider the time from July 2015 to July 2016 to be an anomaly.

As you may notice, it is a roll of the dice. Unfortunately, risk management can’t depend on rolling the dice to make decisions.

What should asset managers do?

Most of the time, portfolio managers hedge themselves against downside movements through different options strategies, like protective puts and 1×2 put strategies, laddering, or by taking another route: going long on volatility in bad times, and shorting volatility in good times to earn some extra basis points.

Some managers avoid the complexity and volatility of dealing in derivatives, buying volatility index (VIX) ETFs and funds that promise a certain exposure towards the VIX. There are two types of VIX products:

  • Direct products (long volatility): These products gain from the increase of volatility, or expected increase in the implied volatility
  • Inverse products (short volatility): These products gain from the decrease of volatility, or expected decrease in the implied volatility

The appeal of these offerings are the implied caps and floors in each product: For example, if volatility increased, the inverse volatility products weren’t expected to go to zero — the expectation was that the bank or ETF sponsor would buy futures to create a floor, usually by going long on VIX futures, to guarantee a minimum value for the fund price. In February, these expectations went unmet.

These products offered a false sense of security to investors seeking protection from volatility. After the February selloff, many products went into either redemption or liquidation, and most of them were inverse volatility products. The ProShares Short VIX short term futures (SVXY), an inverse volatility product, lost nearly 90% of its value, even though it was supposed to have a price floor. The VelocityShares Daily Inverse VIX (ZIV), another inverse volatility product, lost nearly 60% of its value, even though it was expected to have a price floor.

In other words, banks and fund sponsors didn’t have a minimum value for these funds, wiping out hundreds of millions of dollars in value.

In the best-case scenario, the funds that were not liquidated, which were mostly long on the VIX, increased the average volatility of an investor’s portfolio due to discrete moves. The ProShares VIX Short-Term Futures ETF (VIXY) nearly doubled its value over one week in early February, and decreased by nearly 40% afterwards. The iPath S&P 500 VIX short term futures ETN (VXX) nearly doubled its value over one week then decreased by almost 30% afterwards.

Increasing volatility can have a negative effect on the measurements used to report a portfolio’s performance, such as their Sharpe ratios or Sortino ratios, placing portfolio managers in critical situations even when they achieve their desired returns. As a result, the events in February left the long volatility investors reflecting a high-return-volatility performance and dampened risk-adjusted returns. Investors who were short volatility lost a decent amount of money.

Is this an impossible paradox? Can we predict volatility and hedge portfolios against it?

To answer the first question, it is not impossible. It would be a dire situation if going either long or short volatility had equally negative effects. There are some techniques that provide low-cost hedging for a portfolio, without having to deal with VIX.

For the second question, I am sorry to say that all prediction models, including GARCH models and the famous Black–Scholes model, are statistically flawed and have their own drawbacks. But in all cases, rather than try to predict volatility, we should always prepare for it.

In a world where most markets and asset classes are married to each other, we are not in the business of prediction, but rather in the business of survival and preparation for whatever happens.

Ayman Ismail Abdel Hamid, CFA, is a board member and treasurer of CFA Society Egypt.

On 17 April in Cairo, CFA Society Egypt will convene the 2018 Middle East Investment Conference. Register now to attend the conference and join other investment professionals in the region discussing capital market movements and portfolio management.

All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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