Swedroe: Volatility Risk Endures

September 29, 2017

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.


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.


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