Swedroe: Variance Risk Premium Evidence

April 22, 2019

An insurance policy is a means of risk transfer in which a buyer pays to eliminate the possibility of an extreme, rare, downside event—such as premature death, destruction from an earthquake or hurricane, or in the case of financial assets (including stocks, bonds, currencies and commodities), a sharp increase or decrease in the price.

The price of such a risk transfer decomposes into two parts: an expected payout and a risk premium to compensate the seller for the uncertain nature of any payout, which may be sudden and dramatic. Financial markets are full of strategies that resemble insurance or lotteries.

For example, in options markets, the premium to compensate the seller for the uncertain nature of the payout is called the variance (or volatility) risk premium (VRP). This risk premium is rational for both the buyer and the seller. The buyer willingly pays it to create, or to eliminate, uncertainty. The seller charges it for taking the risk. And the evidence indicates that the more remote the risk, the higher the ratio of risk premium to expected payout.

The bottom line is that, over a large sample size, there is an expected fair value set by the probabilities of outcomes, and options sellers charge a premium to that fair value to compensate themselves for providing a risk-transfer service.

Nature Of The VRP

The VRP refers to the fact that, over time, the option-implied volatility has tended to exceed the realized volatility of the same underlying asset. This has created a profit opportunity for volatility sellers—those willing to write volatility insurance options, collect the premiums and bear the risk that realized volatility will increase by more than implied volatility.

Because the VRP’s risks (specifically, when the sale of options performs poorly) tend to show up in bad times (when risky assets perform poorly), we should expect a significant premium, one that cannot be arbitraged away.

Another way to think of this is that investors pay to hedge catastrophic outcomes; they want to transfer the risk of a terrible outcome.

For example, we buy insurance against our homes burning down. Oil producers (such as Mexico) buy insurance against the price of oil falling, and utilities and other users of energy buy protection against the price of oil and natural gas rising. Farmers buy insurance against the price of their production falling, and companies that use agricultural products buy protection against the prices of their inputs rising. Importers buy protection against the price of currencies they buy from rising, and exporters buy protection against the price of currencies they bill from falling. Borrowers of floating rate debt buy protection against interest rates rising, and owners of longer-term bond lenders buy protection against rates rising.

As a result, the VRP should be considered a unique risk premium that investors with long investment horizons and stable finances can harvest because they have the ability to accept the cyclical risks that show up in bad times.

Stone Ridge Asset Management, sponsor of the All Asset Variance Risk Premium Fund (AVRPX), examined the historical evidence on the VRP across stocks, bonds, commodities and currencies from 2008 (the first year of publicly available data for all asset classes) through 2018.

It measured the VRP as the premium of implied volatility to realized volatility using one-month 25-delta options. Delta represents an option’s sensitivity to the price change of the underlying asset, ranging from -100 to 100. The price of an option with 25 delta will theoretically move $0.25 for every $1 move in the underlying asset. Due to data limitations, German five-year and 10-year rates represent data since 2011. The asset class VRPs are the equal-weighted average of the component parts shown.

Here is what they found:

  • The equity VRP was 15%.
  • The foreign exchange VRP was 13%.
  • The commodity VRP was 9%.
  • The interest rate VRP was 14%.

A large body of evidence demonstrates that the VRP is persistent and pervasive as well as robust to various maturities across asset classes and the around the globe. My ETF.com blog on August 2, 2017 presented the evidence from academic studies on the subject.

Summary

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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