A post at FT Alphaville the other day highlighted Theo Casey's take on Professor Eckhard Platen's 2010 paper arguing that there's a chance sellers of variance swaps (e.g., VIX futures and options) might be unable to deliver in a crisis. From the introduction to Platen's paper:
Investors and fund managers alike, have developed an interest in volatility derivatives[,] since these instruments may substantially increase the value of their holdings, even if the equity market index experiences a major drawdown. At least theoretically, these derivatives can provide some protection against severe market downturns. How effective such portfolio insurance is, from a macro-economic view point, remains an open question. In paricular, when a large and increasing number of pension funds, insurance companies and other investors rely on this type of insurance, it is not clear whether the sellers of variance swaps will be able to serve their obligations in a market crash.
Casey, who is the editor and investment director of The Fleet Street Letter, summarizes Platen's thesis as follows:
The problem, in his view, is that volatility offers a payoff asymmetric to the underlying index...A single digit decline in stocks causes a double digit return on the volatility futures. Platen's fear is that if the volatility contracts rise too fast, their issuers—the banks—may not be able to foot the bill....
[Platen] argues that the collateral used by banks selling this kind of protection against index downturns through variance swaps is typically equity—the index itself. Thus at the very time they have to pay up, their assets will be turning to dust.
Even if banks spot this potential risk, Platen believes that rather than ceasing to sell the contracts, they may instead follow the same tactic they employed with subprime mortgages and transfer the risk to other parties.
Casey goes on to weigh the (currently modest) size of the volatility derivatives market against its rapid growth and spread to more investment pools (e.g., pension funds).
On exchanges, trading is sparse around anything other than the CBOE Vix family of products. In January, 7.9m Vix options were traded at the CBOE, as well as 780,000 Vix futures at the CBOE Futures Exchange. Month-end open interest in the futures was 165,000 contracts...the total open interest is abourt $3.3bn. A tidy sum, but hardly enough to trouble the IMF over....
But the volatility craze is only just catching on. The two short years since the Vix hit 81 have been filled with product lauches: correlation indices, skew indices, single stock Vix metric and “Vix-alikes” in other regions and asset classes. Most importantly, pension funds are beginning to adopt tail risk management strategies, of which volatility is usually the principal component.
His conclusion is that “...we have to be humble when thinking about these new asset classes.”
In the time-honoured tradition, an innovation is going mainstream. It is an innovation that has never been put to the ultimate test. Thus, no one knows for sure how the story will end.... What might help the market more than anything is for investors to be realistic about their hedging, and remember there is no free lunch in the investing world. To meaningfully reduce risk one must diversify across asset classes. This is a difficult and boring job—and even if one does it well, risk will remain.
Amen—and yet…the Condor Options VIX Portfolio Hedging Strategy performed stellarly in the sub-prime crisis, when, arguably, volatility derivatives were tested under extreme conditions. We hadn't been subject to the proliferation of variance derivatives that Platen assumes and Casey anticipates—and I agree that we need to be “realistic” with any strategy (i.e., there's always tail risk, no matter where you try to hide)—but right now that day still looks like it's a long way off.
VIX as a Hedging Strategy
The idea behind the VIX Portfolio Hedging Strategy is that we use margin on our long positions (in SPY, DIA, IWM, etc.) to purchase protection from outlier events, in the form of VIX futures or shares in the VXX ETF. The notion of hedging portfolios using long volatility positions isn't new; what's new about this strategy is that it allocates hedging capital by gradually varying the level of exposure as market conditions change.
Although the newsletter strategy presumes VIX futures or VXX shares, personally, I try to balance risk with a combination of VXX and VXZ shares. The former react more quickly to short-term increases in volatility, while the latter still increase dramatically in a crisis, but don't lose as much when volatility declines.
As of last Friday, we're allocating 5% of our long portfolio value to VIX futures, VXX shares, VXZ shares, or a combination thereof. In margin accounts, we don't need any additional capital to hold the hedge position. Allocation percentages are published daily, but a weekly adjustment (market crises aside) has been working well for me.
Additional disclosure: Market-neutral option positions in SPX, RUT, SPY and IBM.