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[Update below]

My approach to investing is heavily influenced by both traditional finance and behavioral finance. I believe that the markets are "weak form" efficient. That is to say it is near impossible to consistently have an "edge" due to information (of the legal kind) or other skills that would lead an investor to consistently outperform the relevant market index through stock picking and market timing.

On the other hand I certainly do not believe in "strong form" market efficiency: that all prices always represent a rational evaluation of all available information so that not only are the markets efficient they are also rational: price=value. It seems unbelievable to any layman that it is controversial to assert that markets can be irrational and prices deviate from any reasonable sense of value yet in fact in academic finance this is indeed a source of controversy. It is pretty clear that markets overshoot: bubbles and busts exist.

But the fact that irrational under and over valuation occurs does not mean that money can be systematically made identifying them. As Keynes and many others have pointed out you (trading against the market irrationality) can run out of money before the market comes to its senses.

I am not looking for a systematic way to call market tops or bubbles, I don’t think they exist. I am far more interested in finding ways to limit the exposure on the downside of a portfolio due to “black swan” events. The expression made famous by Nicholas Taleeb in his book The Black Swan. Such events would be defined as unlikely events with disastrous circumstances, bursting of bubbles, or other low probability events that could have disastrous consequences on a portfolio.

Earlier this month I attended a major ETF conference at Boca Raton Florida. I thought I would get some ideas from a panel entitled “controlling tail risk” –tail is the geek term for the extreme outlying points on a bell curve i.e. low probability events. Ironically enough the conference was held in the midst of a “tail” event in south florida weather: temperatures were in the 30s, the local weather report even included the wind chill data. Yet the panel discussed things like “understanding your client’s risk tolerance” and “risk tolerance questionnaires" with not a word of actual discussion of limiting portfolio risk to extreme events. It would have been a bit like having a panel on preparing for unusually cold weather during a January trip to Florida and devoting the discussion entirely to the issue of how sensitive you are to cold rather than the types of warm clothing it might make sense to pack as a precaution.

Needless to say, I didn’t get any ideas from the panel. Since I have years of background in options, I know that the most direct way to protect against extreme downside moves is to purchase out of the money put options. While this is certainly the most direct hedge for a portfolio, there are several factors that may argue against this approach which I will detail in another post.

There is another alternative which may be more attractive. When one buys a single option one is effectively buying a view on both the underlying security's direction and on volatility. An option price is based on the market's view of future volatility (“implied volatility”) the relationship of the option strike price to the price of the underlying, and the time to expiry.

It is possible to “buy (or sell) volatility” without seeking to profit from movement in a particular direction through the purchase of options The most prevalent way to do this in most markets is to buy or sell an “at the money” straddle = a put and call both with strike prices at the money (at or close to the current market price).

But there is another way to” trade volatility” on the S&P 500 through the VIX index which is the “implied volatility" of at the money options. Up until very recently this could only be done through a futures contract. But through the use of an ETN (exchange traded note) one can purchase an ETN on a volatility index which moves tandem to, but is not identical to, the VIX. The ETN has the ticker symbol VXX and it is based on an index of short term futures on the VIX index.

The VIX is often referred to as the “fear index” with much justification. As markets become fearful demand for options goes up and is reflected in higher option premiums higher implied volatilities on options and a higher VIX. Quiet markets on the other hand bring the VIX lower. As it turns out, holding a long position in volatility through the volatility ETN VXX has many characteristics that make it an attractive hedge vehicle, arguably more attractive than options purchases. While we do not have long term trading data for the VXN its general price behavior corresponds to the VIX which has a longer history.

1.VXX has a very high inverse correlation to the S+P 500. =-.74 Large down movements in the market are accompanied by very large moves up in the VXX.

2. VXX tends to move at a multiple of the size of the market movement in periods of sharp declines. Therefore a relatively small position in the index can offset movements in a large part of the portfolio.

3. Although the VXX will decline during periods of low volatility, it will not go to zero. There might be large losses on the hedge, but unlike options the position need not go to zero because of price movements in the underlying index. There is credit risk on the instrument since it is an exchange traded note. It is conceivable that in the event of a bankruptcy of the issuer, Blackrock (NYSE:BLK), the value of the note could go to zero.

4. Unlike options, a large volatile to the upside for the portfolio will not create losses on the hedge, just the opposite, there is a likelihood that a market that is volatile on the upside will lead to an increase in the VIX and therefore a “windfall gain” on the hedge.

5. Since nothing goes up in a down market except correlation, a position on the VIX even though it is based only on the S&P 500 is likely to serve as a good head for a global portfolio. Major downmoves in the US market are seldom unaccompanied by large drops in global markets. And it seems to be increasingly the case that major downturns in non-US markets spill over into the US market.

During 2008 the S&P 500 experienced a 50% fall, emerging markets a drop of 60%, yet the VIX index experienced an increase of 400% at its highest point and ended the year 100% higher than where it started.

The pattern was similar although not as extreme during other sharp market drops: selloffs the magnitude of the increase in the VIX was a multiple of the magnitude of the fall in the underlying market. A stable market leads to a decline in the VIX (all time low is around 10 ) big upmoves in the market lead to upmoves in volatility but nowhere near as high as during sell off

For that reason, a relatively small position in an ETN linked to the VIX has the potentially of acting as a hedge against large negatives moves on a far larger portfolio. In the extreme example of 2008, a $22,000 position in the VXX would have offset the losses on a $100,000 position in the S&P 500.

Several factors may argue for using the volatility ETN as a “black swan” instead of purchasing out of the money put options:

Leverage: as mentioned, during negative black swan events volatility is likely to move up a multiple of the move in the underlying. In fact, the leverage on this instrument tends to work in the hedger's favor since the move up in volatility in a panic is far sharper than the decline in volatility in response to quiet markets

Bad correlation becomes good correlation: the phenomenon of “the only thing that goes up in a down market is correlation” helps this strategy as the hedge on us mkt volatility works as a hedge of a global equity portfolio.

There will never be a total loss on the hedge due to market movements in the index. Unlike options even in dead markets the volatility index will not go to zero, thus the drag on portfolio returns from the hedge is not as great.
There is, however, credit risk related to this instrument, since it is a note issued by iShares/BlackRock.I in the event of a bankruptcy by the issuer, the note value could decline significantly or even go to zero regardless of movements in the volatility index.

Possibility of windfall gain. Should the markets move up sharply, the investor hedging with the volatility index will reap a windfall gain. Both the underlying long portfolio and the hedge (the long volatility position) will increase in value. In the case of the put option purchased as a hedge there of course would be a sharp decline in value.

Rolling of strikes and maturities. The volatility ETN is a “perpetual index” so there are none of the complexities described above with regard to option positions.

The strategy worked well during the current market decline.

Between Jan 20 and Jan 26 the VXX rose from 27.81 to 31.72, an increase of 14%.
The S&P 500 during that time fell from 113.89 to 109.31 a fall of 4%. So for a $100,000 portfolio invested as follows: $95,000 in S&P 500, loss of $3600;
$5,0000 in VXX the hedge would have created a gain of $700, for a net loss of $2900.

And a portfolio fully invested in the S&P 500 would have generated a loss of $4,000, so the hedge with only 5% of the portfolio created a loss 27.5% less (-$2900 vs -$4000) than an unhedged portfolio.

And as is usually the case in significant down moves, markets move in tandem. The emerging markets index has fallen 6.6% over the same time frame, developed markets: 7%. So the purchased of the US volatility ETN would have functioned as a hedge of a global stock portfolio.

So while there certainly is no such thing as a perfect hedge that protects the downside and retains the potential for upside gains…the volatility ETN certainly merits consideration as part of a portfolio.

Update:

5-year charts here on VIX the volatility index, SPY (US S&P 500), EEM(emerging), EFA (developed) show the relationship between the volatility index and the movements in the stock indices: [click all to enlarge]

Source: In Search of the Elusive Black Swan Hedge: One Idea Worth Trying