Diversification proved to be a relatively ineffective hedge against 2008’s stock market crash, and since that realization almost three years ago, investors have been searching for an efficient means to insulate equity portfolios from a repeat performance.
One asset class that performed well in the face of the crash was volatility—the stock market plummeted in September 2008 and the CBOE Volatility Index (the VIX) soared (see Figure 1). The S&P 500 fell by 47 percent from its September 2008 peak to its trough in March 2009. During that same period, the VIX rallied 126 percent and at one point was up over 250 percent since the September high on the S&P 500. This negative correlation to the S&P 500 led many investors to investigate the VIX as a potential way to protect their portfolios from another collapse. Perhaps VIX, the so-called fear index, would enable managers to develop the portfolio hedge that investors had been seeking.
The VIX was introduced in 1993, but it wasn’t until 2004, when futures were first listed, that investors could take positions in exchange-traded VIX instruments. Trading in VIX futures accelerated dramatically after the launch of VIX-related exchange-traded products in early 2009. As shown in Figure 2, the 30-day average trading volume in VIX futures has increased almost twentyfold since the advent of VIX ETPs. In that period, investments in VIX-related ETPs have increased from zero to $3 billion.
Before looking at specific strategies or asset allocation concepts, it is important to understand the construction of the underlying volatility benchmarks and indexes. The VIX index and instruments related to the index have performance characteristics that differ from other futures-based instruments.
The Fear Index
The VIX1 is a measure of the volatility implied by prices of S&P 500 options for the next two expiries. The option expiries are weighted such that the index measures the 30-day expected volatility of the S&P 500. The components of the VIX are near-term and next-near-term put and call options having at least eight days until expiry, and the square root of the variance of these options is used to calculate the index. As volatility rises and falls, the strike price range of options with nonzero bids tends to expand and contract. As a result, the number of options used in the VIX calculation may vary from month to month, day to day and possibly even minute to minute. It is the use of the square root in the index calculation and the potential for change in the components of the index that make it unrealistic to actually trade the index. The VIX is widely followed by the market and the media, but it is not an investable index.
The negative correlation of the VIX to the S&P 500 would make it an attractive addition to a portfolio. Figure 4 demonstrates that adding a holding in the VIX to a holding in SPX improves the risk-adjusted return.