Swedroe: Volatility Risk Endures

September 29, 2017

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.


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