The general assumption in managed futures is that volatility is a friend to performance, but as 2011 showed us, this won’t always be the case- especially if volatility is choppy and associated with dramatic risk on/risk off moves. In some ways, they’re more “frenemies” than anything else.
Today on a regular ongoing due diligence call with one of our recommended managers, Roland Austrup of Integrated Managed Futures Corp (IMFC), who we’ve been working with since 2009, we learned that he has decided to abide by the whole “keep your friends close, and your enemies closer” routine, incorporating the trade of VIX futures into his trading strategy. As he explained in a recent piece of research:
Since its introduction in 1993, the CBOE Volatility Index (VIX) has become a preeminent barometer for measuring broad equity market volatility. VIX measures the market expectation of 30-day volatility implied by prices of CBOE-listed S&P 500 (SPX) options… VIX itself is not investable, the exchange-listed VIX futures and options contracts have served as a surrogate for exposure to the non-tradable index. In fact, VIX contracts are now the most liquid way globally to trade short-term implied volatility despite their short trading history.
As a Commodity Trading Advisor (CTA) constantly looking for more alpha-generating strategies, VIX futures has appealed to us as an alpha source which is uncorrelated to the existing markets we trade.
The strategy elements in place are definitely fascinating, but the important thing for us was the major emphasis IMFC is placing on the risk management element of it. In particular, the breakdown of the risks associated with trading VIX futures was notably thorough.
Vega: Vega measures the sensitivity to volatility. Since trading VIX futures involves taking directional bets on the volatility, having a VIX futures position will be equivalent to taking the Vega risk.
Theta: Theta is the sensitivity of the derivative’s value to the passage of time (i.e. time decay). The VIX futures term structure priced in the possibility of a future volatility spikes. However, as time approaches to maturity, there is smaller probability of this happening and hence the value of VIX futures will decline. The decline in contract value reflects the time decay for VIX futures. In fact, Theta or time decay is the source of returns for systematically selling VIX futures in “contango”.
Delta & Gamma: Delta and Gamma are respectively the first and second derivatives of the option value with respect to the underlying price. Instead of delta-hedging a basket of options to achieve a pure volatility trade, VIX index is actually calculated from some mathematical equations without holding any options. Therefore, investors do not have to worry about any delta or gamma risk involved in trading the VIX futures.
Interesting stuff. We’ll be watching the trading closely, and look forward to getting a feel for how this new addition to the strategy impacts the performance of the IMFC program.