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.

Cheaper But Expensive
They write: “Option prices may be lower, but they remain expensive in the sense that the long volatility component of one-month options is expected to have negative returns.”

Upon examining the data, Israelov and Nielsen came up with some additional interesting findings. For example: “The volatility risk premium is more variable when implied volatility is high. Its 80 percent confidence interval is 5 percent wide in the lowest implied volatility decile and 19 percent wide in the highest decile. In the lowest risk environment, the most extreme outcome had realized volatility 8 percent higher than implied volatility. In the highest risk environment, the most extreme outcome occurred when realized volatility was 49 percent higher than implied volatility. Although owning a put option provides the same contractual protection in each decile per se, the distribution of outcomes across volatility environments has been very different.”

In other words, while a 5 percent out-of-the-money put provides the same protection at all times, historically, investors have needed the insurance the most when volatility has been high, not low. The authors concluded that while the ex-post cost of insurance was lower at times when volatility remained in the lowest three deciles, “less expensive options in calm markets do not necessarily mean that investors are getting a good deal.”

They also noted that the maximum 21-day return from the lowest four deciles was only 1.7 percent. Given that the cost of the options was more than 1 percent per year, “to buy these options hardly seems like money well spent.”

What About International Exposure?
To examine the robustness of their findings, Israelov and Nielsen also tested whether their results held over a larger universe of international equity indexes.

Specifically, they analyzed index options on the DAX (Germany), Euro Stoxx 50, FTSE (U.K.), Hang Seng (Hong Kong), KOSPI (Korea), the Nasdaq, Nikkei (Japan), Russell 2000 and Swiss Market Index indexes. The evidence was very similar to that found in the U.S.

For example, from the lowest- to the highest-volatility quintile, the realized risk premium persistently increased from 1.6 percent to 3.8 percent. They also found similar Sharpe ratios of about -0.9 percent across quintiles, with the exception of the highest quintile, where it was much worse, at -1.4 percent.

The bottom line is that buying insurance (put options) when volatility is low (the cost is “cheap”) is only a good strategy if investors compare it with buying insurance when volatility is high (the cost is expensive).

Final Test
As a final test, the authors examined how effective buying insurance was against the risk of so-called black swans. They concluded that black swans would have to occur with much greater frequency than they have actually to make buying insurance an effective strategy.

They concluded: “If you believe that the type of black swan event considered in this section is significantly under-represented in our historical record and you are also willing to pay out more than 1 percent of NAV per year in order to buy protection for such an event, then purchasing put options may be rationalized.”

They added this caution: “While it is certainly possible that black swans are under-represented and put options are less expensive than they appear (or even cheaply priced!), we should similarly be willing to also entertain the possibility that black swan events are over-represented in our sample … and put options are even more expensive than they appear.”

However, if do you believe black swans are truly underrepresented, the evidence suggests that a far better strategy than buying puts as insurance would simply be to lower your equity exposure and adapt the “Larry Portfolio” as described in “Reducing the Risk of Black Swans.”

The bottom line is that the research presented by Israelov and Nielsen demonstrates that “put options’ low prices during calm periods give the illusion of value.”

The authors end with this warning: “Buying an option is not a bet that realized volatility will increase; it is a bet that realized volatility will increase above the option’s implied volatility. Buying an option is expected to lose money even when volatility is low and rising if the spread between realized and implied volatility is sufficiently high.”

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.


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