It has historically paid to be a seller of volatility for at least two reasons...
1) Volatility is typically overpriced relative to realized volatility
The chart on the left shows the VIX index (predicted volatility) relative to the forward realized volatility of the S&P 500, while the chart on the right shows the variance between the two (anything > 0 means the VIX index was higher than the realized volatility)
2) VIX futures typically price the cost of longer dated contracts higher
The chart below shows the steepness of the VIX futures term structure. Anything below 100 means the value of the CBOE 1-Month Volatility Index (VIX) is less than the CBOE 3-Month Volatility Index (VXV). This is typically the case to compensate the seller for uncertainty, which benefits a short VIX position (all else equal).
Creating a Model
Given these historical structural advantages of a VIX short, I thought it would be of interest to share how one might make an allocation within a portfolio to capture these benefits while maintaining characteristics of a long stock position. The below analysis goes back roughly to the inception of VIX futures and carves out a portion of a stock allocation for a short VIX position via the S&P 500 VIX Short-term Futures Inverse Index (the index for ETPs XIV and SVXY). An investor can simply carve out a percentage of their allocation (call it 10% or 20%) and call it a day, but a risk weighting scheme has historically added about 1% to returns per year, while reducing risk, and it provides a framework for how one might add additional asset classes to the mix (also shown below).
The Equal Risk Weight Methodology Used Below is as Follows:
Weight next month exposure to the S&P 500 and S&P 500 VIX Short-term Futures Inverse Index by risk weighting based on historical 6-month standard deviation (using month-end data) and rebalance monthly.
Model Version 1.0 (Stock / VIX Short, Equal Risk-Weighted)
Example Weights
Note that this framework resulted in higher modeled performance with better risk-adjusted returns (higher sharpe ratio), though it did come with higher risk in the form of higher standard deviation and higher drawdown.
Model Version 2.0 (Stock / Dynamic VIX Short, Equal Risk-Weighted)
Instead of a static short to VIX futures, version 2.0 allocates to the short VIX position only when the term structure favors a short on a daily basis (i.e. when the previous close was in contango - see chart above or here for more about investing based on the term structure - the weight remains determined by the previous month-end). The modeled results are improved (higher return, higher risk-adjusted return, and lower drawdown), but overall risk in terms of standard deviation remains higher as well.
Model Version 2.1 (Version 2.0, but Scaled Down):
This iteration takes the rules from version 2.0 and waters down the weight of both stocks and bonds with cash to match risk profile of the S&P 500 (note - this is absolutely data mined or I wouldn't have known a ~70% weight to the results from version 2.0 and 30% to t-bills would have resulted in the 14.3% standard deviation of the S&P 500). The modeled portfolio is improved in just about every manner and has an additional 30% of the portfolio now sitting in cash that is available for an alternative allocation. Note a 37.5% weight gets to the same 7.6% return and results in a standard deviation of almost 1/2 that of the S&P 500 and drawdowns of only 1/3 that of the S&P 500.
Model Version 1.1 (Add Bonds to Version 1.0):
This iteration takes the rules from version 1.0 (a static VIX short, even if the VIX term structure is in backwardation), but throws long bonds in the mix. This is more akin to traditional risk parity, so I included the performance of a stock / bond risk parity iteration in the performance chart below as well (i.e. an allocation excluding the VIX short).
Example Weights
The result is an improved sharpe ratio, largely due to the negative correlation of bonds with stocks over this time frame, and more "bang for your buck" that even a small unlevered allocation to a high volatility VIX short provides (more was written on that feature here). Please note this has been the golden age of risk parity, thus this level of performance is unlikely to continue.
See also:
