Swedroe: The Cheap Volatility Illusion

August 24, 2015

As I write this on Aug. 10, despite all the economic problems facing investors (such as Greece, the slowing Chinese economy, a bear market in Chinese stocks, the collapse in commodity prices and Puerto Rico’s default), the VIX index, a measure of the market’s expectation of 30-day volatility, had closed above 14 only once since July 13.

That was July 27, when it closed at 15.6. Even so, that’s well below its historic average of about 20.

If you sort the VIX into decile buckets, the three lowest deciles have average levels of 11.4 percent, 12.8 percent and 14.3 percent. By contrast, the highest three deciles have averages of 23.5 percent, 26.9 percent and 37.7 percent.

Low Vol Means Cheap Options
With historically low levels of volatility, the cost of options is low. And this comes at a time when many investors are worried about the risks in the market, thanks in part to the many “gurus” in the financial media warning about the historically high level of the Shiller CAPE 10 (which is currently at about 26.6 versus its historical average of 16.6).

Thus, it’s no surprise that I’ve had a number of calls from investors asking about the advisability of “taking advantage” of this “opportunity” to purchase some portfolio insurance by going short the VIX index (effectively buying puts on the S&P 500 index). Before you take any action, however, remember that just because something is “cheap” doesn’t mean it’s a good investment.

Roni Israelov and Lars Nielsen—authors of the March 2015 study, “Still Not Cheap: Portfolio Protection in Calm Markets”—researched the question of whether equity portfolio insurance, historically, was a good purchase when the cost of that insurance is relatively cheap.

Here’s What They Found
The premise, or theory, behind it is as follows:

  1. Volatility historically has been mean-reverting
  2. Buying put options provides long-volatility exposure
  3. Go long volatility when it’s at historically low levels, because volatility is likely to revert to the mean

Presented in this light, buying put options now might appear to be a compelling strategy. But does hard data actually support the theory? Israelov and Nielsen begin by noting: “It is well-known that portfolio insurance is expensive on average.”

Translation: being persistently long volatility is a bad and expensive strategy, and there are more efficient ways to reduce tail risk than buying insurance.

For the period March 15, 2006, through June 20, 2014, Israelov and Nielsen found that buying puts lowered returns by 2.5 percentage points and lowered the Sharpe ratio from 0.37 to 0.21, a relative decrease of more than 40 percent. The authors showed that long volatility exposure reduces performance by 2.0 percentage points per year, and the strategy produces a Sharpe ratio of negative 0.83.

However, the insurance did lower downside beta considerably, from 0.85 to 0.47. Simply lowering equity exposure would clearly have been a more efficient alternative. And as my co-author, Kevin Grogan, and I show in “Reducing the Risk of Black Swans,” the more efficient way to reduce left-tail risk has been to lower equity exposure while at the same time increasing exposure to the size and value factors.

What Matters Most

Before answering the question of whether it makes sense to take a tactical approach to volatility (only going long when it’s cheap), Israelov and Nielsen provided this important insight: “It doesn’t matter if implied volatility is at or near its historical low. It doesn’t matter if realized volatility is expected to increase. It doesn’t even matter if realized volatility actually does increase over the option’s life. What does matter is the option’s purchase price (implied volatility) relative to its fundamental value (ex-post realized volatility).”

They found that over the full period for which VIX data was available (Jan. 2, 1990, through June 30, 2014), the ex-post realized risk premium paid was 3.4 percent. What’s more, it was positive 88 percent of the time.

The authors concluded: “Investors who heed analysts’ recommendation to purchase options are not only long volatility—they also face long odds of benefiting from the option purchase.”

Having determined that being long volatility all the time has been a bad strategy, the authors then sought to discover whether it was a good strategy to be long volatility when volatility is low and option prices are historically cheap.

Israelov and Nielsen found not only that the realized ex-post volatility risk premium was positive in every decile, but the realized premium in the three lowest volatility buckets, at 3.1 percent, isn’t really that much different than the 3.4 percent average from all buckets. Even in the lowest VIX Index decile, the realized premium was 2.5 percent.


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