Hedging stock market volatility

(MoneyWatch) The most basic tenet of financial theory is that risk and expected return are related. One widely used measure of risk is volatility. It's well known that unexpected stock market returns are negatively related to the unexpected change in the volatility of stock returns.

Greater than expected volatility leads to negative stock returns -- investors demand a higher risk premium to compensate them for the greater risk. The result is that the discount rate used to value future cash flows increases (dividend or earnings), lowering prices. Thus, there is a negative relationship between future returns (as the equity risk premium investors demand increases) and unexpected increases in volatility.

The knowledge of this relationship has led investors to seek ways to hedge against unexpected increases in volatility. To provide a hedging vehicle, the VIX index was created. The VIX is an index, like the S&P 500. However, it doesn't measure price. Instead, it's a weighted mix of the prices for a blend of S&P 500 index options, from which implied volatility is derived. It was introduced in 1993 in order to provide an index upon which futures and options contracts on volatility could be written. The Chicago Board Options Exchange launched trading of VIX futures contracts in May 2004 and VIX option contracts in February 2006.

It's important to understand that the VIX is a forward, not historical, measure of volatility. It represents investor expectations of future market volatility. If investors become fearful, their demand for portfolio insurance will increase, driving up the price of the VIX. As such, the media often refers to it as the "fear gauge." Let's look at some of the evidence.

The VIX is characterized by periods of relative calm and large spikes. For example, it reached its record high (over 100) during the Oct. 19, 1987, market crash. It also spiked in:

• October 1989, during the "mini-crash" resulting from the United Airlines restructuring failure
• 1990, when Iraq invaded Kuwait
• Early 1991, when United Nations forces attacked Iraq
• 1997 (the Asian Contagion) and 1998 (when hedge fund Long Term Capital Management failed)
• The financial crisis in 2008

The fact that the VIX spikes during periods of market turmoil is why the media cite it as a measure of investor fear. If expected market volatility increases, investors demand higher rates of return on stocks, so stock prices fall.

In the aftermath of each spike, the VIX returned to more "normal levels." From 1986 through October 2008, the VIX averaged about 19. (Note that since 1926 the annual standard deviation of the S&P 500 has been about 20.) Fifty percent of the time, it closed between 14.60 and 23.66 (a range of 9.06 points); 75 percent of the time it closed between 12.04 and 29.14 (a range of 17.10 points); and 95 percent of the time it closed between 11.30 and 37.22 (a range of 22.92 points).

Let's take a quick look at recent history. In January 2004, the VIX was trading at around 18. Until the housing bubble burst in the summer of 2007, it remained below 22.25, trading often in the single digits, reaching a low of 9.36 in November 2006. In July 2007 it crossed 25. In August it crossed 30, before dropping again to about 16 in October. When Lehman failed in September of 2008, it spiked to over 50. In October, it again broke 100, and stayed at elevated levels (basically above 50) for the rest of the year. When the market began its rally in early March 2009, the VIX began to fall, again dropping well below 20 in 2010. We experienced several spikes since then -- during our budget crisis, and whenever fears about the European crisis became elevated

The fact that the VIX tends to rise whenever there are crises is why there is much interest in it as a hedging tool. However, there is one more important issue you need to understand before you consider using the VIX in this way.

As we noted, the VIX is a forward-looking index that measures expectations of volatility. For example, as I wrote this on August 31, the VIX was trading at 17.51. However, the September futures contract (VIX/U2), which expires September 18, was trading at 19.25; the October contract (VIX/V2), which expires October 16, was trading at 21.55; and the November contract (VIX/X2), which expires November 20, was trading at 23.10.

In other words, to profit from your VIX hedge, not only would the VIX have to rise, but it would have to increase by more than the market already anticipates. Future prices being higher than the spot price is called "contango." And contango is typical in the VIX market, occurring perhaps 75 percent of the time. Contango makes hedging via the VIX an expensive proposition. For example, if the VIX remained unchanged at 17.51 until September 18, the contract would have a loss of $1.74 (19.25-17.51), or 9 percent.

Thus, you could think of the cost of the insurance as 9 percent for a period of not even three weeks! The high roll costs have caused huge losses for investors, as you'll see when we review the historical returns.

There are a few logical reasons for the existence of contango. The risk premium for market volatility exists because option buyers are:

• Willing to pay a premium to protect themselves from unknown future crises, a premium that is large immediately after a significant volatility event
• Willing to pay a premium for protection from increasing asset correlations that typically occurs during crises
• Willing to pay the equivalent of a financing premium as they earn a leveraged return

In summary, implied volatility should be systematically higher than realized volatility because option buyers are willing to pay up to avoid incurring "carry costs," and option writers should be adequately compensated for the insurance component embedded in the options they write. Thus, the option writers should earn a risk premium.

The largest and most successful VIX product is the iPath S&P 500 VIX Short-Term Futures ETN (VXX). VXX is designed to mimic a 30-day futures contract on the VIX spot index (Because the VIX "spot" index is not directly tradable, short-term futures are the nearest proxy.) To accomplish this objective, the ETN holds a long position in first- and second-month VIX futures contracts that roll daily. The managers accomplish this by maintaining a balance of front-month (the next futures expiry date) and second-month contracts that keep the VXX always about 30 days out on the curve.

As an example, on T=1, the first day after a contact expires, the VXX "holds" only contracts for the next expiry. By T=15, the VXX consists of 50 percent of the nearest month and 50 percent of the next month's contracts, maintaining the 30 days away from expiry structure. Therefore, each day the VXX "sells" 1/30th of its assets in front-month contracts and rolls them into second-month contracts. Next we'll look at the returns data available from Morningstar.

In 2010, when the S&P 500 returned 15.1 percent, VXX lost 72.4 percent. In 2011, while the S&P 500 gained 2.1 percent, VXX lost 5.5 percent. Through July 31, 2012, the year-to-date return of the S&P 500 was 11 percent and VXX had lost 61.6 percent. August results will only add to the misery. For the month through August 30, the S&P 500 rose from 1,379 to 1,399 while the VXX fell from 13.64 to 11.75.

One other important point to remember is that while exchange-traded notes provide the benefit of tracking their benchmark index, they do entail taking the credit risk of the issuer, Barclay's (and that implied cost should not be ignored just because you don't receive a bill for it).

The bottom line is that using the VXX as a tool to provide portfolio insurance isn't a prudent investment strategy. If anything, the evidence suggests that it would be better to take part of your equity allocation and use it to short the VXX! However, if you are tempted to do this, remember that there are periods when the VIX spikes and you will experience large losses at the same time your equities are losing value. In technical terms, the distribution of returns for being short volatility is negatively skewed and has excess kurtosis.

So if you are going to short volatility, be sure to keep the allocation small, and don't use any leverage. Combining leverage with short volatility strategies has led to hedge fund blow-ups.

Image courtesy of Flickr user Tracy_O