The New Asset Class: Investing in (or against) the VIX (Part 2)

Earlier this week, we gave a brief recap of CBOE Director of Education’s Russell Rhoads presentation of VIX Futures, but that was just half the fun. We also had four professional hedge fund managers (technically, commodity trading advisors since these are VIX futures) share how they view volatility as an investment opportunity, not just a fear gauge. They aren’t just any hedge fund managers, these are four of the first professional traders to offer volatility focused investment programs to investors on a standalone basis using VIX futures and VIX options.

Here’s what you should know about VIX Futures and the people and systems that trade them professionally.

Is VIX a hedge or an alpha generator?

While most see the utility of VIX Futures as a means to hedge a portfolio – many of our panelists don’t view it as a hedge whatsoever. Mike Thompson of Typhon and Tim Jacobson both agreed that they see it mainly as an alpha generating tool, depending greatly on the market environment (ie. it’s not as simple as just buying or selling the VIX, a more sophisticated strategy needs to be used). Lawrence McMillan sees it as a bit of both; using VIX options as the alpha generator, VIX futures as a hedge on that alpha, noting that the public likely views it as “insurance” in your portfolio.

Brett Nelson, of Certeza stood the question on its head, asking the audience to think of the S&P 500 as a hedge of the VIX, not vice versa.

Are the infamous VIX spikes cause for alarm, or joy, for your program?

The general consensus of spikes in the VIX was that they can be scary in the moment, depending on the positioning of the portfolio coming into such a spike (remember these guys are equally as comfortable betting on increases as decreases in the VIX). Tim Jacobson went on to say they welcome these spikes as they can provide opportunity but that we all must “respect them.”

But each panelist mentioned that the spikes often be joy-inducing shortly followed by – as the spikes typically represent over buying and over protection by other market participants. That overbuying can cause market inefficiencies which is exactly what their programs look to extract.

There was also discussion around when and how the spike happens – with panelists commenting that a spike on top of already elevated volatility is quite different than a spike from historically low volatility levels (with the latter being a bit more dangerous). Thompson also made an interesting point here that recent spikes have seen shorter and shorter ‘half lives’, so to speak, with the VIX more quickly reverting to the mean after recent spikes than seen in years past.

How do these models work?

There’s not enough room for the dissertation it would take to really get into these models and how they work, but each tends to approach the VIX from a market structure standpoint – trying to capitalize on its unique tendencies being a qaudrivative of sorts, where arbitrage opportunities can exist when one of the legs of that derivative of an index of a derivative of an index doesn’t keep pace with the other legs.

Brett Nelson of Certeza describes his approach as “stat arb”, or more officially – statistical arbitrage – which in this case manifests itself on the VIX as volatility arbitrage. In simplistic terms, the program will calculate where it believes various contract months of VIX futures should be priced at, and upon finding a mispricing, either buy or sell to take advantage of that pricing potentially reverting to where it should statistically be given the inputs.

Tim Jacobson of Pearl Capital uses the market structure in a slightly different way, using the VIX futures to monetize the differential between the volatility implied by the VIX and the volatility actually produced by the S&P 500. The Pearl strategy, therefore, can play the VIX futures when they are rising or falling and independent of overall market direction.

Mike Thompson of Typhon is a relative value program focused on the shape of the VIX futures curve. He looks for price inefficiencies in VIX futures by going long front month / short back month or short front month / long back month depending if VIX futures is in contango or backwardation.

Finally, Lawrence McMillan essentially “sells” volatility, utilizing VIX options, not VIX Futures, and attempting to capture the premium decay therein. Unlike the other three managers, Lawrence sees the VIX futures as a way to hedge his short option profile from big spikes in volatility.

Where is volatility and the VIX going from here?

We couldn’t let these pros out of the room without asking what they see in the current volatility environment and it could be going into 2017. While many systematic managers complain about the central bank intervention messing with normal market movement, the panel seemed resigned and comfortable with this current regime until it changes.

Of course, they all felt we’re currently in a very low volatility environment, which some pointed out makes what they do a little more difficult (as the deltas on any increases in volatility can be greater than they otherwise might be coming from such depressed levels). From there, there were answers as varied as ‘I Don’t care what environment we’re in – it doesn’t matter to our dynamic model’, to comments that Ray Dalio’s Bridgewater is looking at Japan as a proxy for what might happen in US markets following massive stimulus.

The crowd asked whether this unpredictable presidential campaign would lead to a very unpredictable (and therefore market volatile) election day/week/month; to which the panel generally answered, no. The reason is because that information is already known who the candidates are and that one of them is a little unorthodox. Essentially, it’s already “priced in” to the market.

Tim Jacobson had a great talking point here, saying to think of the VIX as a radar screen – where all of the known information the market is reflected on the screen in various blips and dots. The sum of all that information comes out to be the current VIX level.  Continuing, he stated that unless one of those known blips becomes larger, or a new unforeseen blip hits the screen, the VIX won’t move. The larger the blip and more unexpected its arrival on your screen (and closeness to your ship) the larger the movement in the VIX will be.

Should ‘Volatilty’ be an asset allocation?

This may have been a better question for a panel of asset allocators, but the answers were interesting nonetheless. After the standard disclaimers by the panel that they don’t know the specifics of each investor’s portfolio and thus not giving specific advice on specific portfolios – we got answers centering around a baseline of ‘yes, this should definitely be part of a balanced portfolio; Along with comments that it’s not just a good diversifier to a traditional portfolio, but also a great add to an alternatives portfolio which typically relies on momentum based, volatility expansion seeking strategies.  Tim Jacobson had the interesting perspective that they work at a family office and designed the program just for this reason, to provide exposure in the portfolio to volatility as an asset class; while Brett Nelson considers 30-40% an appropriate allocation.

We’ll add our own commentary here, that it is a very attractive space from our viewpoint, being generally a low margin usage product with low correlations to the rest of the managed futures space. This allows investors to add it to current portfolios of managers with very little impact in terms of additional capital or additional portfolio level drawdowns and added volatility.

P.S. – If you want the want a recording of the webinar they were most recently featured in, download it here.