Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

Using the VIX to manage equity and mutual fund portfolios

How can the VIX volatility index help you to make investment decisions in the equity and mutual fund markets in terms of entry and exit points and determining proper asset allocation for your portfolio? Proper use of the VIX as an indicator can boost portfolio returns and help manage risk but before we can use it effectively we need to review what the VIX is and what it does. The VIX measures implied volatility of the S&P 500 looking forward to give the market’s expectation for volatility over the next 30 days. Implied volatility for at-the-money and out-of-the-money S&P 500 call and put options are used to calculate the VIX value using a weighted average to derive the expected volatility. A VIX value of 30 or greater generally indicates high volatility in the market, and a VIX value lower than 20 generally indicates low volatility in the market. A VIX value of 20 is considered average volatility, and we can obtain the standard deviation of monthly return over the past twelve months by dividing 525 by the VIX value. As a frame of reference, the long-term market average annual return is 15%, which translates into a standard deviation in monthly return of 4.3% (from Risk Outlook paper by Geoff Consadine 2006). For our purposes, we will use the VIX as a proxy for the standard deviation of monthly returns.

An important fact to keep in mind about the VIX and market volatility is that it tends to persist over an extended period of time, so the buy-and-hold investor should have ample opportunity to re-balance their portfolio and achieve optimal asset allocation. Research by Charles Schwab found that when the VIX was above 20it remained there 78% of the time three months later, and when it was below 20 it remained there 85% of the time three months later. This is important during periods of high volatility because there is increased potential for higher gains, bit also for higher than normal losses.

Now we are not chartists, so we are not looking to trade ranges in the market back and forth, we are simply trying to determine optimal entry and exit points for our funds so that we can re-balance our portfolios and maintain proper asset-allocation for our investment objectives. To effectively use the VIX to help mange your portfolio, an investor needs to accurately calculate portfolio beta. Beta is a measure of how sensitive your portfolio is to movement in the broader market with 1.0 being a portfolio that moves in lockstep with the broad market. A portfolio with a beta of 1.5 for example will move 50% more than the market and a portfolio with a beta of .74 will move only 74% of the move in the broad market. An investor also need to be able to account for non-systematic correlation, or the components of the portfolio that beta does not measure.  The only way to capture all of these components of portfolio risk is to use a Monte Carlo simulation, since this calculation is beyond the capabilities of most individual investors computing tools monitoring the VIX is an excellent qualitative alternative.

Generally speaking a portfolio with a high beta will get riskier as the VIX increases, so during periods where the VIX is below 20 we would look to re-balance our portfolio to achieve a lower beta if we are averse to increased risk. Research by Charles Schwab found that both large and small-cap stocks generally showed higher returns (about 2.6% each) during the quarter after the VIX fell below 20 vs. the quarter after it rose above 20 (1.5% for large cap and 2.4% for small cap). Both large and small-cap returns were 50% less volatile after the VIX fell below 20 compared to after it rose above 20. So this indicates that the VIX as a forward-looking indicator has been accurate in terms of predicting volatility. Value stocks outperformed growth stocks by quite a wide margin (3.1% large-cap value vs. 2.1% for large-cap growth and 3.3% small-cap value vs. 1.9% small-cap growth) during periods after the VIX dipped below 20. Conversely, large-cap growth showed gains of 1.7% vs. gains of 1.1% in large-cap value in periods after the VIX rose above 20.

The implications for buy-and-hold investors seem to be quite straightforward. When we put all of these facts together, they point in the direction of re-balancing our portfolio when the VIX falls below 20 towards a greater percentage invested in equity value stocks or funds with a lower overall portfolio beta to achieve greater returns. The VIX is currently trading around 24 as of July 21, 2010, with a range of 15.23 to 48.20 over the past 52 weeks, so it is important to keep a close eye on portfolio allocations. When it comes to selecting mutual funds, remember to pay close attention to the expense ratios, loads and fees; and all things being equal to select the fund with the least expenses. If your portfolio is over-weighted in equities and the VIX is above 20(as it is now), consider selling out of high beta equities or reducing stock fund holdings to get back to your target equity levels. Because volatility levels tend to persist, there is a greater sense of urgency to re-balance out of high beta stocks or out of and over-weighted equity portfolio for risk-averse investors when the VIX is trading above 20 than there is to re-balance in a low volatility environment. The potential for increase gains as well as increased losses is much greater in a volatile market and risk-averse investors such as those nearing retirement age would be wise to be aggressive in getting back to their target equity allocations.

The VIX is widely used by professional money managers to manage their portfolios, and can be an effective portfolio allocation and risk-management tool for the individual investor as well assuming it is used properly and the investor knows their risk tolerance and is disciplined about maintaining investment targets.

Disclosure: No positions