This note outlines the main issues surrounding the use of volatility futures and U.S. Treasury bonds as part of a tail-hedging program. Each approach presents a unique set of challenges and deserves to be looked at separately.
In our view, passive allocations to CBOE Volatility index futures are likely to prove costly and ineffective over long time horizons. In contrast, active VIX futures strategies that take into account the term structure of VIX futures might help mitigate costs and crystallize hedging gains. The use of Treasury bonds as hedges creates challenges because negative correlations between Treasuries and equities might not hold in the future. In addition, Treasury allocations need to be sizable in order to have material hedging effects, and current low interest rate levels create a less convex payoff profile for the asset class.
The VIX, which is listed on the Chicago Board Options Exchange, is based on real-time prices of options on the S&P 500 index, and is designed to reflect investors' consensus view of future (30-day) expected stock market volatility. Futures contracts on VIX were introduced in 2004. These futures cover various maturities, which creates a VIX term structure similar to that of interest rates observed in fixed-income markets. VIX futures are cash settled and, if held to maturity, provide direct exposure to 30-day implied S&P 500 volatility. As expected, volatility tends to spike in periods of market stress, making VIX futures potentially attractive as portfolio hedging tools.
Over longer holding periods, passive investments in VIX futures can prove quite costly for two main reasons:
- Negative carry
- Strong mean reversion properties of volatility
Negative cost of carry is a function of the term structure of VIX futures. Because the VIX term structure is generally positively sloped (i.e., “in contango”), each time a maturing VIX future contract is replaced with a new longer-dated contract, investors tend to sell low and buy high.
Additionally, volatility tends to mean revert, thus requiring an active approach in order to crystallize gains from a spike in VIX futures. More specifically, after the financial crisis passive allocations to VIX futures experienced substantial losses as equity market implied volatilities reverted toward lower, longer-term averages and the VIX term structure reverted back into contango. As an extreme example, an investor owning the front month VIX future contract between Sept. 22, 2008, and Nov. 20, 2008, would have gained 351% only to give all of the hedging profits plus 82% of the initial capital back over the next three years, ignoring transaction costs.
Active VIX futures strategies might alleviate some of these issues. For example, a tactical hedge signal derived from the term structure of the VIX index might allow investors to take advantage of spikes in the VIX while potentially offering downside protection during periods of low or falling equity market volatility. This may be achieved by not investing in VIX futures until the signal is triggered. In addition, this signal may provide a mechanism to systematically monetize profits before the index reverts to its normal levels. The risks of using a strategy such as the one described above include not having portfolio insurance every time there is a risk event as well as other implementation challenges.
If a passive strategy is selected, investors can try to minimize the negative cost of carry by choosing a point in the VIX futures curve where the slope is flatter. However, this does not protect from the other drawbacks mentioned.
Allocations to “safe haven” assets such as U.S. Treasuries are a popular alternative for protecting investor portfolios in times of a market drawdown. This is because U.S. Treasury bonds tend to appreciate in times of crisis as capital is reallocated away from riskier instruments. Allocating to Treasuries has indeed been profitable as nominal yields have declined since the onset of the 2008 financial crisis: nominal yields on 10-year Treasuries have fallen from a historical peak of roughly 5.1% to just over 1.6% in November 2012. During this period, correlations between Treasuries and the S&P 500 index have stayed largely negative. In addition, actions by the Fed have given investors further assurance in that interest rates are not likely to go up anytime soon. As a result, many are actively considering an allocation to Treasuries as a way to hedge portfolios against tail events.
While an allocation to Treasuries may very well be justified from a diversification perspective, using Treasuries to hedge other risky assets presents some challenges as well. In our view the recently observed negative correlations can hardly be counted upon to be persistent enough to warrant an allocation as an explicit portfolio tail hedge. First, negative correlations are not necessarily the rule. Prior to the financial crisis positive and negative correlations have alternated for long periods of time. Second, because Treasuries are much less volatile than equities, one would need a lot more Treasuries to provide an effective hedge, thus requiring a large allocation. Lastly, Treasuries are currently trading at yields close to an all-time low. This creates a minimal carry and also exposes the investor to an asymmetric return pattern, as yields likely have more room to increase rather than fall further over a longer time horizon.
For investors looking for protection against extreme market moves, neither VIX futures nor Treasury bonds provide a magic bullet. VIX futures strategies, if employed, need to take into account the shape of the term structure to be sustainable. Similarly, while limited Treasury allocations may well belong in a diversified portfolio, larger allocations meant as tail hedges may actually expose the portfolio to new risks. Both instruments may have a role in the portfolio, but a measured and balance approach is warranted.
Nicolae Cristea is an associate director at Pacific Alternative Asset Management Co., Irvine, Calif., working in portfolio management focusing on opportunistic investments, risk management, and portfolio construction.
Todd Groth is a manager in PAAMCO's risk management group.