Abstract
We investigate the potential role of Exchange Traded Products (Notes) as vehicles to trade volatility (here proxied by the VIX index) as an asset class in a fully optimizing asset allocation framework, subject to long-only constraints. In back-testing, recursive exercises based on an expanding window of data from February 2010 to February 2016, we find evidence that VIX should enter with non-negligible weight most portfolio strategies and that under many circumstances, long VIX positions may generate positive risk-adjusted performance benefits. However, the volatility positions that can be managed and traded through (one of) the most popular US exchange-traded notes (VXX) fails to deliver such realized, out-of-sample benefits under all utility functions and for a range of assumptions on investors’ risk aversion. Even though the turnover implied by VXX does not appear excessive, taking into account transaction costs worsens considerably its performance and even casts doubts as to whether volatility ought to be considered as an alternative asset class altogether. Direct strategies that trade appropriate futures on the VIX improve somewhat realized performance, but not enough to tilt over the balance of our conclusions.
Highlights
While it has been long acknowledged that volatility tends to be higher when excess returns are negative, recent years have been characterized by a rollercoaster-type variation in stock prices and volatility that has greatly emphasized this well-known fact: while most indicators of volatility skyrocketed to unprecedented levels between October 2007 and March 2009, the US market dropped by around 50%, amid frenzied trading and panic waves
We investigate the potential role of Exchange Traded Products (Notes) as vehicles to trade volatility as an asset class in a fully optimizing asset allocation framework, subject to long-only constraints
While if the VIX were directly available, we would expect to see a modest demand for bonds at best and the level of portfolio risk would be controlled by varying over time the commitment to VIX, thanks to its low or negative correlations, when an investor can at most trade VXX the result is that the most effective way to limit risk exposure is to reduce the overall weight of real estate and equities in favor of relatively riskless bonds, a rather traditional strategy
Summary
While it has been long acknowledged that volatility tends to be higher when (market) excess returns are negative, recent years have been characterized by a rollercoaster-type variation in stock prices and volatility that has greatly emphasized this well-known fact: while most indicators of volatility skyrocketed to unprecedented levels between October 2007 and March 2009, the US market dropped by around 50%, amid frenzied trading and panic waves. Under these circumstances, rising risk aversion prompted investors to look for alternative asset classes able to limit their losses by hedging negative stock (and real estate) returns in bear states. It may be possible to replicate the VIX by investing in the underlying basket of options, it appears either technically hard or costly to continuously replicate VIX index returns this way, as such a strategy would entail investing in a large number of options and rebalancing the position at least on a daily basis (see the discussion in Whaley, 2009)
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