Swedroe: Volatility Risk Endures

There are a multitude of alternative investments for investors to consider, largely because Wall Street is exceptionally good at creating products, and at creating demand for those products, even when there shouldn’t be. However, among the many alternatives from which to choose, there are really only a few you should contemplate.

They …

• Are supported by the academic literature, meaning they have provided premiums that have been both persistent and pervasive, come with intuitive risk-based or behavioral-based explanations, and survive implementation costs.
• Can be implemented using products under SEC regulation.
• Tend to have low correlation with the returns of traditional portfolio assets.
• May not necessarily be cheap by index fund or ETF standards, but don’t come with the typical “2-and-20” hedge fund fees.

Among the few that meet these criteria is the variance risk premium (VRP). The VRP refers to the fact that, over time, option-implied volatility has tended to exceed realized volatility of the same underlying asset. (Note that the popular VIX is a measure of implied volatility.)

VRP has been well-documented, and is best known in U.S. stocks. For example, Stone Ridge Asset Management examined the VRP for the 10 largest stocks for the period 1996 through 2012. Breaking down the period into three subperiods, they found a persistent and stable premium.

From 1996 through 1999, the VRP was 4.3%. From 2000 through 2009, it was 3.9%. And from 2010 through 2012, it was 4.1%. Researchers at Stone Ridge also found strikingly similar patterns in the implied volatility curves around the world.

Global Trend

In a November 2011 paper, “The Variance Risk Premium Around the World” (Federal Reserve System Board of Governors International Finance Discussion Paper), Juan Londono found similar results for VRP.

Research into VRP in U.S. stocks has found not only that options have traded about 4 percentage points above subsequent realized volatility, but also that, from January 1990 through September 2014, the implied volatility of S&P 500 Index options has exceeded realized index volatility 85% of the time—the premium is highly persistent.

It’s important to understand that this should not be interpreted to mean the option market tends to overestimate future volatility. Instead, the more likely explanation is that option prices incorporate a risk—or insurance—premium. Most investors are risk-averse, and so are willing to pay a premium to hedge downside risk. Buying volatility insurance options provides that hedge, or insurance.

Profit Opportunity

The large premium also exists because of a supply and demand imbalance: There likely are far more natural buyers of volatility insurance options than sellers. 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.

Investors are willing to pay a premium because risky assets, such as equities, tend to perform poorly when volatility increases. In other words, markets tend to crash down, not up. Thus, the VRP isn’t an anomaly investors should expect to be arbitraged away.

And because the risks of the VRP (the sale of options performs poorly) tend to show up in bad times (when risky assets are performing poorly), investors should expect a significant premium.

Another way to think about this is that investors pay to hedge catastrophic outcomes. They want to transfer the risk of a terrible outcome, like their house burning down or the price of oil climbing to $200 a barrel. So, they knowingly and willingly pay above fair value to eliminate it.

Thus, VRP should be considered a unique risk premium that investors with long horizons and who are financially stable (which allows them to take on cyclical risks that show up in bad times) can harvest.

Stress-Testing VRP

Wei Ge contributes to the literature on VRP with the study “Stress-Testing Volatility Risk Premium Harvesting Strategies Based on S&P 500 Index Options,” which appeared in the Summer 2017 issue of The Journal of Index Investing.

Ge observes that, despite strong evidence favoring the VRP, many investors “are wary of selling options, especially put options, because of the perceived downside risk.”

He writes: “They fear that shorting put options may incur significant losses, especially during market turmoil when other assets are performing poorly. Put option sellers only collect limited premiums, but market crashes may force them to pay large sums. With limited upside benefit and potentially large losses, put-selling strategies are unintuitive to many investors and represent the least attractive investment risk-return profiles.”

Ge then presented evidence that, when put-selling strategies are viewed as a substitute for equities, the “common perception represents a significant misunderstanding.”

To make his case, Ge examined how two model VRP portfolios, a “dedicated VRP portfolio” and an “overlay VRP portfolio,” performed over five financial crises in the past 30 years. The crises were Black Monday in 1987, the recession of 1990, the Long-Term Capital Management crisis in 1998, the 2000-2002 internet bust, and the 2007-2009 global financial crisis.

Post-Market Crises

The study further stress-tested the two VRP portfolios in three artificially constructed scenarios modeled after the most damaging market crises during the 20th century: the Great Depression of 1929 to 1932; the 1938 recession; and the stagflation and Organization of the Petroleum Exporting Countries embargo of the 1970s.

He noted that the performance of options-based VRP-harvesting portfolios during such stressful market conditions depends on two main factors: the beta of the VRP strategy, and the speed of the market crash.

Ge’s dedicated VRP portfolio is allocated 50% to S&P 500 Index exposure, 50% to Treasury bills and also includes a short strangle that involves shorting S&P 500 Index puts and calls layered on top of the base assets. Both short positions of put and call options were fully collateralized by the underlying S&P 500 Index assets and Treasury bills. This construct has a long-term regression beta of 0.54 against the S&P 500 Index.

The overlay VRP portfolio’s allocation includes a short strangle as well, but one that involves shorting equal notional S&P 500 Index options (i.e., 100% S&P 500 Index puts and 100% S&P 500 Index calls), plus 100% Treasury bills. This construct has a long-term regression beta of 0.07 against the S&P 500 Index.

Both portfolios use a delta of 20% for S&P 500 Index options that expire in a month. Ge also examined their performance with 30%, 40% and 50% deltas.

Stress Test Results

For the 31-year period January 1986 through December 2016, Ge found the overall returns of the two VRP constructs were similar to the S&P 500 Index—10.35%, 10.56% and 10.16% per year for S&P 500, dedicated VRP portfolio and overlay VRP portfolio, respectively. However, both VRP portfolios had significantly lower volatility.

For example, at 20% delta, the standard deviation of the S&P 500 was 15.1, but 8.5 for the dedicated VRP strategy and just 5.2 for the overlay VRP strategy. Thus, the Sharpe ratio of the dedicated VRP strategy was almost twice that of the S&P 500 (0.85 versus 0.46) and the Sharpe ratio of the overlay VRP strategy (1.32) was almost three times as large.

However, the VRP strategies exhibited more negative skewness (-0.79 for the S&P 500, -2.36 for the dedicated strategy and -4.85 for the overlay strategy).

Ge noted that the negative skewness indicates the return series usually has small positive gains and large negative losses. This is a risk/return profile generally shunned by investors (who tend to prefer more lotterylike distributions, which are characterized by mostly poor returns with the potential for extreme positive outcomes).

On the other hand, the worst-case drawdown (based on monthly data) was -51% for the S&P 500, but -26% for the dedicated strategy and just -16% for the overlay strategy.

Similar Results

The results were generally fairly similar at higher delta levels (especially at the 30% delta level), though they tended to deteriorate (lower returns, higher standard deviation, lower Sharpe ratios and greater maximum drawdowns) as delta increased.

Ge also found that, in general, the higher the beta level, and the faster the market crash (such as in the 1987 Black Monday market crash or the Long-Term Capital Management crisis in the summer of 1998), the larger the VRP strategy’s losses.

On the other hand, as previously noted, even in the worst scenarios, VRP strategies perform significantly better than the underlying equity index. When the market crash is slow-paced, the drawdowns in VRP components are especially mild.

Ge further found that the VRP strategies recover more quickly after the drawdowns due to the elevated option premiums (the cost of insurance increases after losses/higher volatility). And when Ge examined simulated performance during three of the worst market crashes, 1929-1932, 1937-1939 and 1973-1974, he found similar results.

The daily maximum drawdowns of the VRP strategies were much less than those of the S&P 500 even in the worst crashes.

For example, the worst-case daily drawdown for the S&P 500 during the Great Depression period of 1929-1932 was -88%. It was -67% for the dedicated VRP strategy and -49% for the overlay VRP strategy.

Summary

Ge’s study demonstrates that investors’ aversion to selling options (especially put options) due to the fear of significant losses in a financial crisis may be unjustified.

Historically, VRP portfolios, when implemented with out-of-the money index options, have delivered superior risk-adjusted returns in the long term, and outperformed the market during periods of financial distress.

Ge added that the cost of constructing option strangles is low, especially with exchange-traded standard index options, because there’s significant liquidity and market depth for standard S&P 500 Index options.

He concluded: “The resilient performance of VRP strategies during financial crises is another meaningful benefit of and motivation for including the VRP in investors’ portfolios via option-selling methodologies.”

I would add that while the VRP is best known in U.S. equities, and most volatility products focus on them, diversification across many asset classes has the potential to improve VRP returns by 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.

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