One technique that can be used to mitigate the risk of spikes in VIX to a short volatility strategy is to add a long position in the short-term VIX futures index. At first blush, it may seem odd to combine a long position with an inverse position on the same index, but there are a number of reasons specific to daily resetting instruments and the VIX futures index that make this strategy interesting:
- Daily resetting exposure has positive convexity
- The VIX short-term futures index has a negative mean return
- Index returns are not normally distributed—positive skew
The positive convexity of daily resetting instruments and the non-normal distribution of the index result in performance characteristics that may not be readily apparent. Figure 13 presents a combination of an inverse position (90 percent) and a 2 times long position (10 percent) in the index. The positions are rebalanced to their target weights on a quarterly basis.4 The performance of the combined positions results in a more balanced return profile than the 100 percent inverse position—the addition of the long volatility position provides a hedge against exposure to a spike in volatility.
A simple example is useful to more clearly explain why the combination performs as it does it. A portfolio consisting of notionally equally weighted holdings of a long position in the index and short position in the index would have a neutral position in the index on day 1—the value of the combined holding should be unchanged at the end of the day. On day 2, because of the resetting of the two positions, the strategy would no longer be neutral to the index. An increase in the index would result in the portfolio having a net long position to the index, and a decrease in the index would result in a net short position.
Rebalancing each of the underlying positions at the end of the day would result in a change in the weighting of the overall portfolio—since the exposure of each position resets, the net exposure responds in a nonlinear fashion, and the net exposure tends to be long as the index increases, and short as the index decreases. To be clear, it is the individual positions in the index that are reset every day, not weightings in the portfolio.
The concept behind the strategy is that the holding in the inverse position enables the investor to benefit from negative roll yield (from contango in the futures market) in most market conditions, while the long position enables the strategy to benefit from a spike in volatility. The cost of the position is the expected decay.
A combination of a long and short position can result in an attractive return profile relative to the S&P 500 (see Figure 14). Determining the desired weighting of these positions and the frequency of rebalancing the portfolio to the target weightings needs to be determined by the manager. It is likely that managers will want to adjust the portfolio weightings over time because of portfolio drift, changes in the shape of the VIX futures curve or because of their view on volatility.