Owning VIX May Shield Your Portfolio

By David Russell

Investors could have avoided losses during 2008's sharp selloffs declines using the VIX volatility index as hedge, according to a new study by the Chicago Board Options Exchange.

By holding a 3 percent allocation to at-the-money one-month calls on the VIX, a traditional portfolio of stocks, bonds, and alternative assets would have appreciated 21 percent between August and December, the CBOE report showed. Without the hedge in place, it would have experienced a 20 percent decline.

The VIX, which tracks the implied volatility of the S&P 500 index, is a broad measure of the market's perception of risk. It spiked to 89.53 amid last October's market collapse and traded as low as 24.80 earlier this month. CBOE has offered futures contracts on the VIX since 2004 and options on the instrument since 2006. (optionMONSTER Volatility Sonar report carries daily webcasts from the VIX trading pit by market maker Jamie Tyrrell of Group One trading.)

The study also said that holding 10 percent of assets in VIX futures would have cut investors' losses to just 4 percent. Or, if investors had dedicated a quarter of their portfolio to VIX options 25 percent out of the money, they would have earned 97 percent.

However, while owning the VIX may protect wealth in turbulent times, it can be costly as a long-term practice. Data from CBOE showed that an unhedged portfolio would have significantly outperformed until the crisis began last summer.

Jim Paulsen, chief investment strategist at Wells Capital Management, said the VIX can be a difficult hedging tool because it's difficult to pick the correct month and correct strike price to offset changes in a portfolio.

"They're priced all over the map," Paulsen said in an interview yesterday. "Depending on which one you buy, it can have very different results."

Paulsen, a large traditional manager with $375 billion under management, said he doesn't know anyone who uses the VIX and prefers S&P 500 futures as a hedging tool.

Volume in the VIX rose 11 percent to 25.9 million contracts in 2008 after more than tripling in 2007, according to CBOE. Today the volatility index stands at 30.41, down 2.84 percent on the session, after falling under $25 less than a week ago.

(Chart courtesy of tradeMONSTER)