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Why Volatility Could Become A Mainstream Hedging Option

U.S. Government bonds have been the traditional equity exposure hedge, ticking all kinds of boxes including uncorrelated returns, low-cost of access and confidence. With interest rates down at 0% these days, however, there is not a lot of room for the rate drop tailwind to increase their value – and consequently, their usefulness - as an equity market hedge. 

What bonds never offered anyway is the opportunity to make exponential gains in times of significant equity market distress. The use of options trading strategies as a hedge has been around for a while; they offer numerous benefits including the ability to define a maximum loss (specifically, the aggregated cost of all of the options purchased in a defined time period) and a 24/7 insurance policy that basic stop-loss orders can’t offer due to after-hours trading risk. In the last twelve months, these strategies have had some bad press, in part due to CalPERS’ then-CIO Ben Meng telling Institutional Investor in March last year that the high cost of adding options-based strategies into their portfolio was a factor in the U.S.’ largest public pension pulling the plug.

For those disillusioned with bonds, or options-based strategies, adding long volatility exposure into a portfolio is one of the other available tools. Long volatility bets pay off most handsomely when volatility spikes; the VIX has closed at 70 or over on just eleven occasions in its history, all of which came either in March last year or in October or November 2008, both situations when equities sold off rapidly. The behaviour of the VIX exhibits one of the traits that hedging purists look for.

“Particularly during times of crisis, volatility is significantly negatively correlated to the S&P 500,” said Scot Billington, Portfolio Manager at Covenant Capital Management. “That’s one of the hallmarks of a true equity hedging instrument.”

Volatility disciples like Billington say that one of the other benefits of adding long volatility exposure into portfolios is that the upside is unbounded; whilst long equity exposure has a maximum loss of 100% of the invested capital (assuming zero leverage), long volatility exposure has a limitless payoff due to its theoretically infinite price. Additionally, adding equity market volatility exposure means that you can double your money if an increase in volatility is driven by a jump in the underlying equity exposure.

Of course, it’s not perfect. You can lose both ways if equities are falling consistently in a less volatile fashion. According to Billington, the hallmark of a good volatility trader is an ability to understand – and therefore profit from - the VIX term structure because you can reduce costs by not always hedging the portfolio.

“Portfolio insurance is very expensive, particularly if it is perpetual – it’s the “perpetualness” that adds much of the expense,” he said. “So, being able to model the VIX term structure and understand when to put a long volatility trade on and when to take it off can help significantly reduce that cost which is all additive to returns.”

Actively managing a long volatility trade – i.e., putting it on when the VIX term structure dictates, taking it off when not – is key to the success of the hedge because a passive investment in the VIX will look very similar to a long options position.

“The VIX term structure is usually in contango, where the price of the front month futures contract is higher than the cash price. This contango decays as time passes as the two are required to be equal at expiration, and the decay will look very similar to the decay of an option. The cost of a passive VIX hedge will look eerily similar to that of a long option, as it should be, because financial markets are primarily efficient. That’s why volatility exposure will need to be actively managed so that your return stream does not look like the VXX ETF. Active volatility management does not try to predict when the market will go down or volatility will go up; good volatility management believes what current market prices say and implements volatility hedges when the VIX term structure indicates that those hedges offer the greatest protection – that is, the expected profit in an equity decline - for the least premium {the expected loss in an equity rally], said Billington. 

Some equity bulls claim that equities might still be undervalued, and that the equities bull market has gas left in the tank. That may be, but investors still need to hedge – diversity being the only free lunch in finance and all that. Billington says that actively managed long volatility ticks all the boxes.

“Hedging is as important for offense – because it lets you put more money in the market - as it is for defence, i.e., protecting your money that is in the market,” he said. “Ultimately, a good hedge needs to make more on down moves that it loses on up moves because that improves the risk adjusted return of the total portfolio. Long volatility, managed correctly, can do that primarily because it has such an attractive amount of exponentiality - it can rally so much during a crisis that small positions which would have small adverse effects during bull markets can explode during crisis periods. Add that to its versatility and cost-benefits and I think you’ll see more investors taking a closer look in the coming years.

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