A new research paper casts some doubt on using volatility as an asset class. The warning isn’t unexpected, given that the broad themes of the paper’s findings have been discussed for years. Nonetheless, “The Hazards of Volatility Diversification Volatility” (by Carol Alexander and Dimitris Korovilas at the University of Reading) is a timely reminder that owning (or shorting) volatility directly can be a complicated affair.
Until recently, such warnings were academic beyond the world of professional money management. But with the rise of publicly traded funds that replicate volatility in something approaching its pure form, the opportunities and risks of this asset class (if we can call it that) are available to the average investor. Don’t misunderstand—volatility has some intriguing attributes that make it worthy for consideration as a portfolio diversification tool. But those traits come with a number of caveats. Do the challenges offset the advantages? Possibly, although much depends on the investor and how volatility is integrated with a portfolio.
Volatility comes in many forms, although it’s defined here as the popular VIX Index, which tracks “market expectations of near-term volatility conveyed by S&P 500 stock index option prices,” according to the CBOE. Perhaps the leading strategic benefit of the VIX, which is securitized in a number of exchange-traded products, is its generally persistent negative correlation with the equity market.
The VIX usually moves in the opposite direction of stock prices. Consider a chart of recent history that compares the SPDR S&P 500 (SPY) with the iPath S&P 500 VIX Mid-Term Futures ETN (VXZ). Looking at both products side by side clearly shows a negative relationship—a pairing that can come in handy for hedging the stock market’s potential for large losses.
In the grand scheme of portfolio management, however, the negative correlation is both a help and a hindrance. The help arises because the VIX offers a reliable offset to equity market losses. But it’s a hindrance because a buy-and-hold approach to volatility is likely to end up as a net loss in the long run.
That’s partly because of the relatively high expenses of volatility-related products. You can buy equity market beta in ETFs for as little as 9 basis points, but volatility fund expense ratios will pinch you from 85 basis points and up.
The other problem is that in the long run, volatility’s expected return is probably zero vs. a positive performance outlook for stocks. That’s a function of the positive cash flows linked with businesses. Corporations will earn a profit over time. But volatility is akin to a commodity, which means that there are no cash flows. Gold and oil don’t generate earnings, and neither does volatility. That implies that the VIX will be a losing proposition over time, after factoring in expenses and opportunity costs. As a broad brush forecast for the long run, the VIX’s expected return is probably zero. Reviewing the last 20 years of the VIX suggests as much. The volatility measure has bounced around a lot in the short term, but after two decades it’s more or less back where it started. The stock market, by contrast, has increased by roughly 280% over the last 20 years, based on the S&P 500.
That nature of the VIX inspires a tactical application to using this index. Of course, that introduces a new set of risks. As the new paper from Alexander and Korovilas advises, forecasting the optimal periods when volatility is useful is difficult, at best:
The problem is that such crises are extremely difficult to predict and relatively short-lived. In other words, equity volatility is characterised by unexpected jumps followed by very rapid mean-reversion, so expectations based on recent volatility behaviour are unlikely to be realised. In short, by the time we are aware of a crisis it is usually too late to diversify into volatility.
No wonder that Alexander and Korovilas recommend that “volatility is better left to experienced traders such as speculators, vega hedgers and hedge funds.” Such challenges motivate looking for more cost-effective long-term hedges for strategic-minded investors. One example is a new generation of products that offer a more investor-friendly hedging of the potential for sudden, dramatic declines in stocks—the so-called fat tail risk, or as Nassim Taleb refers to it in his best-selling book on the phenomenon generally: The Black Swan: The Impact of the Highly Improbable. For instance, some financial planners use securities linked to Deutsche Bank’s Emerald Index, as Jerry Mccollis, chief investment officer at Brinton Eaton, told me in a recent article I wrote for Financial Advisor magazine.
A cautious approach to using volatility as an asset class proper is generally sound advice, although almost everyone should monitor the VIX and other volatility metrics for context about the market and economic cycles. Yes, volatility is only one tool for evaluating investment opportunities, but it’s a productive one for offering additional perspective. One reason is because volatility tends to cycle in a semi-predictable way, as the chart below illustrates.
In fact, predicting volatility is a bit less hazardous compared with forecasting asset returns directly. That’s related to the fact that volatility’s long run expected return is zero. One benefit of this somewhat less-mysterious long-run future for volatility makes it useful for assessing risk levels as an indirect clue about market returns. Unusually low levels volatility, for instance, may be a sign that equity prices are ripe for a correction. In 2007, the year before the stock market suffered its worst calendar-year performance since the Great Depression, volatility was unusually low by historical standards. The opposite is also worth pondering. When volatility spikes, as it did in the financial crisis, the cyclical nature of the VIX suggests stock market performance may be set for better days.
That’s not surprising, given the intimate connection between volatility and markets. As noted Stock Market Volatility (edited by finance professor Greg Gregoriou): “Volatility is an inevitable market experience mirroring 1) fundamentals, 2) information, and 3) market expectations. Interestingly, these three elements are closely associated and interact with each other.”