Since the advent of the modern portfolio theory, asset allocation is thought to be one of the most important aspects of investment. The theory assumes that risk equates to volatility and then states that risk is positively correlated with reward, i.e. higher risk is associated with higher returns, and lower risk is associated with lower returns. This assumption is used by money managers to form broad decisions on asset allocation as shown below:
Why Does Asset Allocation Matter?
Asset allocation provides diversification for investors to lower their risk profile. For optimal asset allocation, assets have to be uncorrelated with each other, i.e. perform in different ways. But, stocks and bonds are sometimes positively correlated. For instance, over the last decade, both stocks and bonds have moved upwards, except during the stock market crash from 2008-2009.
The prevailing belief is that both stocks and bonds are currently in the mature stage of their respective bull runs. Once the unprecedented flow of liquidity by the three central banks (the Federal Reserve, European Central Bank, and the Bank of Japan) stops, subsequent inflation and higher interest rates will likely put an end to the stock and bond market bull runs.
Volatility is a Good Alternative Asset Class to Own
What about investing in volatility itself as an asset class? Volatility is tracked by the Volatility Index [VIX], which was introduced to the public by the Chicago Board of Options Exchange in 1993. The VIX measures future volatility by calculating the prices of out-of-the-money calls and puts 30 days out. I recently commented that the VIX was sitting at historic lows in this article, but since then, it has risen somewhat due to conflict in the Middle East and tensions between Russia and Ukraine.
Viable asset classes that can contribute to portfolio diversification should be uncorrelated. When comparing against stocks (benchmarked with the S&P 500 index), volatility (benchmarked with the VIX) typically goes in the opposite direction to stocks. Over the last 5 years, the S&P 500 index has gone up 102% while the VIX has gone down 48%. This indicates that volatility is a good hedge when maintaining a long-term position in stocks. These two components will form a solid basis for a well-diversified portfolio.
Holding Volatility is a Problematic Trade
There are several ETFs and ETNs that currently track volatility, but these are very problematic to own long-term. Popular ETNs include:
- iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX)
- VelocityShares VIX Short-Term ETN (Pending:VIXX)
- VelocityShares Daily Inverse VIX Short-Term ETN (NASDAQ:XIV)
- iPath Inverse S&P 500 VIX Short-Term Futures ETN (NYSEARCA:XXV)
- VelocityShares Daily 2x VIX Short-Term ETN (NASDAQ:TVIX)
Most of these are required to rebalance their portfolios on a daily basis, which involves selling some front month options and buying some second month options. During contango, second month options are more expensive than front month options, resulting in a counter-intuitive buy high, sell low strategy. Contango occurs ~80% of the time for the VIX explaining why over time, most of these ETNs have markedly declining returns regardless of volatility levels. For instance, the VXX has lost an incredible 96% of its value since inception in 2009.
New Vehicles for Investing in Volatility
The managers at KKM Financial, a Chicago-based Investment Advisory firm, have over 75 years of experience in trading volatility. They have devised the ARMOR index, which uses a proprietary strategy for tracking volatility. Jeff Kilburg and Brian Stutland, the CEO and CIO of KKM Financial, respectively, had this to say about the ARMOR index [ARMOR]:
We have found a way to strip away the time decay inherent in many other available products that follow volatility and in doing so, have created a better and more efficient vehicle for investing in volatility. We use proprietary methodology that tries to find the cheapest decaying volatility on a daily basis. We are able to identify overvalued volatility products and also short that. Our ultimate goal have a total return that captures 70% of the upside of the VIX but only 30% of the downside.
Source: Personal communication with Jeff Kilburg and Brian Stutland.
Investing in the ARMOR index is possible via the KKM ARMOR mutual funds, RMRIX and RMRAX, that were introduced very recently on June 11, 2014. The caveat with these funds is relatively high management costs with an expense ratio of 2.45%. However, the ARMOR index does a good job of tracking the VIX with little evident time decay, as shown below.
With asset allocation in mind, KKM financial also has the U.S. Equity ARMOR index [USARM], which is 82% long U.S. large cap stocks and 18% long volatility. Investing in this index is possible via KKM U.S. Equity ARMOR mutual funds, UMRIX and UMRAX that were also introduced very recently on June 11, 2014. This allocation of assets between U.S. large caps and volatility is proposed to replace the traditional 60% equities and 40% bonds portfolio put forth by the modern portfolio theory.
With volatility at such low levels, investing in volatility is a smart defensive position for investors. As an asset class, volatility is negatively correlated to a long position in stocks and can be established as a defensive position against future corrections in the stock market. There are several ETNs that track volatility, but issues like contango and time decay eat away at long-term returns for all these ETNs. A third generation of products like KKM ARMOR and U.S. Equities ARMOR funds are much less susceptible to these issues and should serve well for investors seeking to buy and hold volatility or to hedge volatility.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.