Swedroe: Variance Risk Premium Evidence

April 22, 2019


Diversification has been called the only free lunch in investing. And diversification is investors’ only relief from systemic and unforecastable market risks. Effective diversification requires uncorrelated investments as well as a look beyond traditional stock and bond indexes to other areas of risk and return, such as reinsurance, alternative lending, carry and the VRP. Thus, the key to successful investing is pursuing a combination of strategies across low-correlating assets to produce a broadly diversified portfolio.

While the VRP is best known in U.S. equities (so most volatility products focus on them), diversification across many asset classes has the potential to improve VRP returns through reducing portfolio volatility. This is both intuitive and empirically observable in historical data, which shows low correlation of the VRP across asset classes, including commodities, currencies and credit.

Before investing in the VRP, or any strategy that exhibits negative skewness, you should be aware that, while such strategies can consistently accrue small and consistent gains over many years, rare, large losses disproportionately occur in bad times. It’s this poor timing of losses that helps explain the large required risk premiums.

For example, a simple strategy that involves capturing the S&P 500 volatility premium lost more than 48% in October 2008. However, volatility premium strategies tend to recover quickly, more so than other asset classes, because it is precisely in the immediate aftermath of a crisis event when the volatility premium is richest. This is similar to how insurance companies, which raise premiums after incurring large losses from catastrophic events, operate.

Implementing a VRP strategy requires sophisticated technology infrastructure, low-cost execution, automated trading, and broad and diversified exposure to the asset class. The potential for large losses means that attempting to monetize the variance risk premium may not be suitable for all investors. However, investors with long-term investment horizons—including institutional investors or high net worth individuals, who are willing and able to bear the unique risks involved—may be in a good position to take advantage of the VRP and potentially harvest superior risk-adjusted, long-term returns.

The VRP provides another unique source of risk and return that investors can access, one that has the potential to improve the efficiency of diversified portfolios. Diversifying sources of risk across investment factors (or unique sources of returns) that have demonstrated persistent and pervasive premiums capturable after costs has been shown to be a superior way to improve performance versus the alternative of pursuing the holy grail of alpha, which is becoming a more elusive quest as the market becomes more efficient over time.

Stone Ridge All Asset Variance Risk Premium Fund (AVRPX)

To access the VRP in a diversified way, investors should consider Stone Ridge Asset Management’s All Asset Variance Risk Premium Fund (AVRPX). The fund, which has a 10% volatility target, systemically sells thousands of listed and over-the-counter options and futures across equities, credit, interest rates, foreign exchange, volatility (the volatility of volatility) and commodities (such as livestock, agricultural products, energy and metals) markets around the globe.

Like the other fund families Buckingham Strategic Wealth uses (AQR Capital, Bridgeway Capital Management and Dimensional Fund Advisors), Stone Ridge takes a systematic approach to investing rather than trying to guess the future. Thus, this fund aims to give investors systematic access to the diversified risk premiums across options markets. Collecting these premiums historically has been profitable on average and over time. To reduce the costs of implementation, the fund persistently acts as a provider, not a taker, of liquidity to the options markets.

The fund’s inception was April 2015. Over the last eight months of that year, the fund returned 5.05%. In 2016, the fund returned 7.64%. In 2017, the fund returned 10.47%. In 2018, a year of sharply increasing volatility across stocks, currencies and commodities, the fund lost 12.18%, demonstrating the nature of the risks and that the VRP is not a free lunch. One result was that the increased volatility led to an ex ante increase in the VRP.

In the first three months of 2019, as volatility subsided and the fund benefited from the higher premiums, the fund returned 3.04%. And as I write this, as of April 15, the fund was up 4.28% year to date. From inception, over its four full years of existence, the fund has provided a total return of 14.4%. (Full disclosure: My firm, Buckingham Strategic Wealth, recommends Stone Ridge funds in constructing client portfolios.)

Diversification across various types of securities, whose VRPs are relatively uncorrelated, reduces the volatility of the overall portfolio, allowing the fund to scale up positions beyond its assets under management and to achieve expected returns that are equitylike. Since inception, the fund’s correlation with global equities (the MSCI ACWI) was 0.3%, and its correlation to bonds (the Barclays U.S. Aggregate) was just 0.1%.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.

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