Mastering Volatility

Although the u.s. stock market took has taken investors for a wild ride over the past year, it has largely remained unchanged. It’s enough to drive risk-adverse clients up a tree.

After reaching a 50-year high in volatility, the S&P 500 (SPY) delivered flat performance in 2011 while the Dow Jones Industrial Average (DIA) gained 5.5 percent.

What can advisors do to hedge volatility? How can they calm their client’s nerves? Are VIX ETPs the answer?

One barometer of stock market volatility is the CBOE Volatility Index also known as “the VIX.” The VIX is a forward looking tool that measures the expected future volatility of the S&P 500 stock index for the next 30 days. The VIX is quoted in percentage points and it was first introduced in a research paper by Professor Robert E. Whaley at Duke University.

Today, the VIX indicator has become a popular gauge of investor fear and complacency. A high VIX reading signals fear whereas a low reading means increasing risk appetite among investors. By using a weighted blend of various S&P index options, the VIX attempts to estimate the implied volatility for U.S. stocks.

Late last October, three-month volatility for the VIX peaked at a record level of 191.59. This surpassed previous levels of elevated stock market volatility in late 2008, when the VIX traded around 190. The median VIX reading over the past 10 years has been 92.56.

The same stock market volatility that treated a select group of Wall Street titans with courtesy hasn’t been so friendly as of late. Hedge funds that previously thrived on stock market peaks and valleys hit a brick wall in 2011. Renowned managers like John Paulson that once could do no wrong, got whipsawed.

Paulson’s Advantage Plus fund lost around 52 percent in 2011 after making incorrect bets on Bank of America, Hewlett Packard and gold. Paulson became a Wall Street folk hero after making billions of dollars with bearish bets on subprime mortgage debt during the financial crisis. In 2010, he personally raked in more than $5 billion in profits.

Crispin Odey a London based manager who accurately predicted a banking collapse, was also among the worst performers last year. His $2.4 billion stock fund lost almost 25 percent in value.

Hedge Fund Research reported that hedge funds lost 5 percent on average last year compared to flat performance for the S&P 500. For long/short equity managers, it was one of the worst 12-month periods since the early 1990s. 

VIX Strategies

Instead of avoiding volatility, some advisors set aside a portion of their clients’ portfolios to trade it. Since it’s impossible to invest directly in the VIX, the next best choice is to trade ETPs that are linked to it.

The ProShares Short VIX Short-Term Futures ETF (SVXY) aims for a return that is inverse the return of S&P 500 VIX Short-Term Futures Index. If short-term volatility in the S&P falls, SVXY is designed to increase. Since SVXY aims for that opposite exposure for just a single day and holding it for longer periods could result in performance returns that are different from the target return for the same period. These differences are caused by many factors, like compounding of daily returns, fees and (what else?) stock market volatility. 

For advisors that want a bullish trade on volatility, the ProShares VIX Mid-Term Futures ETF (VIXM) and VIX Short-Term Futures ETF (VIXY) both offer VIX exposure but with different time frames.

The S&P 500 VIX Mid-Term Index has been negatively correlated to the S&P 500 over the past several years, minus 0.77 in 2009 and minus 0.86 in 2010. It’s also generated relatively low beta compared to the VIX, indicating less sensitivity to price movement. VIXM and VIXY aim for 1x daily performance.

For leveraged long VIX exposure, the ProShares Ultra VIX Short-Term Futures ETF (UVXY) shoots for double or 2x daily leverage to the S&P 500 VIX Short-Term Futures Index. All of the ProShares VIX ETFs charge annual expenses of 0.95 percent.