This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by Mike Venuto, co-founder and chief investment officer of New York-based Toroso Investments.
Over the past few years, there has been a lot of discussion about volatility as an asset class. The recent turmoil in the market has reignited this debate.
In my opinion, volatility is not an asset class; rather, it’s a market factor that all investors are inherently long. Factors are idiosyncratic risk that traditional index investors inadvertently accept. Assets are tangible; they can grow and compound value.
Volatility is a behavioral result or return characteristic, and usually a bad one. Unless an investor explicitly limits volatility, they are long this factor. The advent of VIX exchanged-traded products (ETPs) was intended to provide investors the ability to mitigate the exposure to this factor.
The unintended consequence of these innovations was to create an opportunity for astute investors to profit from others’ desire to purchase volatility insurance.
What Volatility Really Is
Before delving into the intricacies of these ETPs, let’s clearly define the volatility factor. Realized volatility is simply a measure of standard deviation or investment performance outside of historical norms.
Since the market trends upward, most spikes in volatility usually correspond with negative economic events. Additionally, realized volatility erodes the positive effects of compounding returns.
This is best illustrated by Jeremy Siegel’s volatility paradox, which notes that returns are not geometrically offsetting. A loss of 10 percent in value requires a gain of 11 percent to go back to the original value. Volatility exponentially amplifies the breakeven requirements; a loss of 25 percent needs a 33 percent positive return to reset. Clearly mitigating this factor can have a positive effect on portfolio performance.
Historically, investors have attempted to limit volatility through diversification and asset allocation. Over long market cycles, this has worked, but in times of extreme stress—like 2008, or most recently, during August of this year—correlation of investments increases and the negative impact of volatility trumps the benefits of diversification.
The Need For Short-Term Tools
Investors with shorter time horizons need tools that implicitly mitigate the volatility factor; hence, the advent of volatility ETPs.
Most volatility ETPs seek exposure to the VIX index. The VIX index is a measure of implied volatility, which calculates the anticipated future standard deviation of the S&P 500 based on options prices. The VIX index is unique in that it does not compound, and always mean-reverts.
Unlike an asset, it cannot go to zero, and it cannot go to infinity. Historically, the realized standard deviation of the S&P 500 has been about 16 percent. Over the past 20 years, the average value of the VIX has been about 18, indicating an anticipated volatility or implied volatility of 18 percent. It is common that implied volatility is higher than realized, and this spread is translated into the cost of purchasing insurance on realized volatility.
Most ETPs that offer exposure to the VIX do so using futures. Essentially the underlying indexes combine long and/or short allocations of at least two VIX futures contracts.