Managing The Strategy
The exposure to the long and short positions can vary significantly due to the performance of the VIX futures index, and therefore it is necessary to manage this strategy. The manager needs to determine how frequently to rebalance the positions to the target weights and what those target weights should be from time to time.
As mentioned earlier, the midterm futures index has a lower beta to VIX than the short-term index, and does not respond to the same degree as the short-term index to temporary spikes in volatility. By the same token, the contango (and therefore the negative roll yield) in the mid-term index is generally not as severe as for the short-term index.
Given the differences in the characteristics of the indexes, another approach to the hedging strategies is to take a long position the midterm index and an inverse position in the short-term index (see Figure 15). Not surprisingly, substituting the midterm index for the short-term index results in a portfolio that is less responsive to spikes in VIX than those presented earlier, but that performs better when volatility is more restrained. For this reason, the manager will likely adjust target weights to reflect the differences in the expected performance of the short-term and midterm futures indexes.
The analysis assumes the portfolio weights are rebalanced quarterly. While only three portfolios are considered here, there are clearly a large number of combinations that could be employed in the development of different strategies. As shown in Figure 16, each strategy has different performance profiles, and it is up to the manager to determine which approach represents the best fit for the portfolio and market view.
Developing cost-effective strategies to hedge sell-offs in the equity markets is challenging. The negative correlation of the VIX to the S&P 500, the performance characteristics of the VIX futures indexes, and the convexity of daily resetting instruments enable sophisticated managers to design strategies to hedge significant equity market sell-offs and more efficiently execute their views on volatility.