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DRS vs. VIX Strategies — Strategy Comparison Series

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VIX Strategies – Easy as It Sounds?

As part of an ongo­ing series try­ing to make sense of the broad, catch-all cat­e­go­ry called “liq­uid alter­na­tives,” this post will explore one of the newest and most eso­teric alter­na­tive strate­gies: volatil­i­ty.

As has been the case in this series, we will dis­cuss:

  1. What are the dri­vers of returns in this strat­e­gy?
  2. What are the risks of this strat­e­gy?
  3. What role does this strat­e­gy play with­in a port­fo­lio?
  4. How does the giv­en strat­e­gy com­pare to the Defined Risk Strat­e­gy?

For most of 2017, volatil­i­ty has been very sub­dued. The most fre­quent­ly cit­ed mea­sure of volatil­i­ty, the VIX, has been at lev­els not seen in a decade. The shrewd investor might try to cap­i­tal­ize on antic­i­pat­ed increas­es of mar­ket volatil­i­ty by invest­ing in one of the new volatil­i­ty-based exchange trad­ed prod­ucts (ETP). There are over two dozen ETPs or mutu­al funds in the Morn­ingstar data­base that attempt to cap­i­tal­ize on volatil­i­ty in some shape or form, up from zero in 2009. This cat­e­go­ry includes long volatil­i­ty and short volatil­i­ty strate­gies, lever­aged and unlever­aged, ETNs and ETFs, and as of 8/21/2017 has an aggre­gate AUM exceed­ing $4.6 bil­lion. They are used as hedg­ing vehi­cles as well as spec­u­la­tive plays.

While bet­ting on volatil­i­ty might seem like a bright idea, it is much eas­i­er said than done. The unfor­tu­nate real­i­ty is the long-term per­for­mance of volatil­i­ty-based ETPs has been atro­cious. The aver­age year-to-date return in the volatil­i­ty cat­e­go­ry, through August 21st, 2017 has been -16.40%. Over the last three cal­en­dar years, the aver­ages have been -23.68% (2016), -26.38% (2015) and -21.25% (2014). Why is this?

Volatility Based ETPs Performance Table | Swan Blog - DRS vs. VIX Strategies

Source: Morn­ingstar Direct

Drivers of Returns

A lot of the prob­lem stems from the fact that most of these prod­ucts are based on VIX futures, or futures on the CBOE Volatil­i­ty Index. But just what exact­ly is the VIX? A lot of peo­ple com­mon­ly refer to the VIX as the “fear gauge” but that descrip­tion leaves a lot to be desired. What is VIX actu­al­ly mea­sur­ing? How is it cal­cu­lat­ed?

When you get down to it, the VIX is cal­cu­lat­ed by infer­ring the implied volatil­i­ty of the S&P 500, using the prices of a bas­ket of short-term puts and calls on the S&P 500 as an indi­ca­tor of mar­ket expec­ta­tions for future volatil­i­ty. While from an aca­d­e­m­ic stand­point there is some log­ic to infer­ring future volatil­i­ty from option prices, what the VIX actu­al­ly mea­sures are the sup­ply and demand of short-term options.

Also, from a prac­ti­cal stand­point, the VIX is not an investable index. Unlike a stan­dard stock index where one can sim­ply pur­chase and hold the stocks in the prop­er weights, no one has yet devised a way to direct­ly buy the VIX.

Instead, most prod­ucts that try to cap­ture the VIX move­ments do so via the use of short-term futures. Futures are of course anoth­er type of deriv­a­tive, so a future on the VIX is real­ly a deriv­a­tive of a deriv­a­tive. Futures have their own unique pric­ing com­plex­i­ties. In the case of VIX futures, the futures almost always trade at a pre­mi­um to the VIX, a sit­u­a­tion known in the futures mar­ket as “con­tan­go.”  The term struc­ture of futures resem­bles the yield curve, where typ­i­cal­ly the longer-dat­ed secu­ri­ties are worth more than short-term secu­ri­ties.

Futures Term Structure in Standard Contango | Swan Blog - DRS vs. VIX Strategies

Source: Swan Glob­al Invest­ments



Because these are short-term con­tracts, a VIX futures strat­e­gy must con­stant­ly be buy­ing futures that are almost always more expen­sive today than they will be in the future. As the futures con­tract gets clos­er to deliv­ery date they lose val­ue, slid­ing down the curve. In order to main­tain expo­sure in futures, this process is repeat­ed again and again. In prac­ti­cal terms, this means con­sis­tent­ly main­tain­ing a posi­tion in VIX futures will almost always lose mon­ey.

Negative Roll | Swan Blog - DRS vs. VIX Strategies

Source: Swan Glob­al Invest­ments

In addi­tion, most volatil­i­ty ETPs are pas­sive­ly man­aged. This is tricky when volatil­i­ty con­di­tions change extreme­ly fast. Any­one who has kept an eye on dai­ly move­ments in the VIX or relat­ed ETPs knows that dou­ble-dig­it dai­ly moves are not uncom­mon. Yet many volatil­i­ty ETPs are method­i­cal­ly man­aged in a pas­sive fash­ion and are not designed to react to chang­ing mar­ket con­di­tions.

Final­ly, the very fact that the prices of volatil­i­ty ETPs are so volatile them­selves makes them inap­pro­pri­ate as a long-term invest­ment vehi­cle and imprac­ti­cal as a hedg­ing vehi­cle. As dis­cussed in a pre­vi­ous blog post, vari­ance drain dete­ri­o­rates the long-term val­ue of any invest­ment.

Gen­er­al­ly speak­ing, the more volatile an asset and the longer the hold­ing peri­od, the more vari­ance drain will dimin­ish its val­ue. Since volatil­i­ty ETPs are so volatile, the impact of vari­ance drain is espe­cial­ly pro­nounced.


Role in a Portfolio

If one intends to use volatil­i­ty ETPs to prof­it from volatil­i­ty, the time hori­zon must be very short—not much longer than a few days or weeks, in most cas­es. In oth­er words, volatil­i­ty ETPs are bet­ter suit­ed for spec­u­la­tive pur­pos­es. The fac­tors discussed—contango, pas­sive man­age­ment, and vari­ance drain—make volatil­i­ty ETPs a poor choice for hedg­ing or long-term invest­ing.

At this point, an astute investor may won­der, “If long volatil­i­ty strate­gies have lost so much mon­ey so con­sis­tent­ly, then why shouldn’t we flip the script? Wouldn’t a short volatil­i­ty strat­e­gy mint mon­ey?”

There are short volatil­i­ty ETPs avail­able, and yes, their per­for­mance of late has been eye-pop­ping. The fact that real­ized volatil­i­ty has been less than implied volatil­i­ty is the ide­al sit­u­a­tion for a short vol strat­e­gy. The con­tan­go phe­nom­e­non works for, not against, a short strat­e­gy.

That said, the oth­er con­cerns regard­ing volatil­i­ty plays remain true for short strate­gies. Short strate­gies are also very volatile and can lose a lot of mon­ey quick­ly. They are usu­al­ly pas­sive­ly man­aged, so los­ing posi­tions can snow­ball quick­ly, wip­ing out months of gains. Vari­ance drain is very much a con­cern in a high­ly volatile prod­uct, and the impact of vari­ance drain will be mul­ti­plied in a lever­aged prod­uct. The graph below shows the price move­ments on the SVXY, a short volatil­i­ty prod­uct.

ProShares Short VIX Short Term Futures | Swan Blog - DRS vs. VIX Strategies

Source: Morn­ingstar Direct, Swan Glob­al Invest­ments

Dur­ing the August 2015 cor­rec­tion, the SVXY lost over half its val­ue in ten trad­ing days. A short while lat­er, the ETF again lost almost half its val­ue between Decem­ber 1st, 2015 and Feb­ru­ary 11th, 2016.


VIX ETPs vs. Defined Risk Strategy

If one wish­es to poten­tial­ly har­vest the so-called volatil­i­ty pre­mi­um over longer time hori­zons, it is the opin­ion of Swan Glob­al Invest­ments that you need to do so direct­ly. If you want to seek prof­it from the fear and volatil­i­ty that is priced into cur­rent options, you typ­i­cal­ly must trade the options them­selves.

Also, giv­en how quick­ly things change in the options mar­ket, it is essen­tial to have active man­age­ment and strict risk con­trols in place to mit­i­gate and man­age the risk of a volatil­i­ty cap­ture strat­e­gy. This approach to pre­mi­um har­vest­ing is one of the com­po­nents of Swan’s Defined Risk Strat­e­gy (DRS).

For 20 years the DRS has sys­tem­at­i­cal­ly attempt­ed to col­lect the volatil­i­ty pre­mi­um by sell­ing out of the mon­ey calls and puts on the S&P 500. The DRS com­bines volatil­i­ty cap­ture, long expo­sure to the mar­ket via ETFs, and hedg­ing tech­niques in a sin­gle strat­e­gy seek­ing to pro­vide con­sis­tent returns through­out ris­ing, declin­ing, or flat mar­kets.

For more about how the Swan DRS com­pares with oth­er strate­gies, check out pre­vi­ous posts in our Strat­e­gy Com­par­i­son Series:


About the Author:

Marc Odo, Marc Odo, CFA®, CAIA®, CIPM®, CFP®, Director of Investment Solutions - Swan Global InvestmentsMarc Odo, CFA®, CAIA®, CIPM®, CFP®, Direc­tor of Invest­ment Solu­tions, is respon­si­ble for help­ing clients and prospects gain a detailed under­stand­ing of Swan’s Defined Risk Strat­e­gy, includ­ing how it fits into an over­all invest­ment strat­e­gy. For­mer­ly, Marc was the Direc­tor of Research for 11 years at Zephyr Asso­ciates.




Impor­tant Notes and Dis­clo­sures:

Swan Glob­al Invest­ments, LLC is a SEC reg­is­tered Invest­ment Advi­sor that spe­cial­izes in man­ag­ing mon­ey using the pro­pri­etary Defined Risk Strat­e­gy (“DRS”). SEC reg­is­tra­tion does not denote any spe­cial train­ing or qual­i­fi­ca­tion con­ferred by the SEC. Swan offers and man­ages the DRS for investors includ­ing indi­vid­u­als, insti­tu­tions and oth­er invest­ment advi­sor firms. Any his­tor­i­cal num­bers, awards and recog­ni­tions pre­sent­ed are based on the per­for­mance of a (GIPS®) com­pos­ite, Swan’s DRS Select Com­pos­ite, which includes non-qual­i­fied dis­cre­tionary accounts invest­ed in since incep­tion, July 1997, and are net of fees and expens­es. Swan claims com­pli­ance with the Glob­al Invest­ment Per­for­mance Stan­dards (GIPS®).

All Swan prod­ucts uti­lize the Defined Risk Strat­e­gy (“DRS”), but may vary by asset class, reg­u­la­to­ry offer­ing type, etc. Accord­ing­ly, all Swan DRS prod­uct offer­ings will have dif­fer­ent per­for­mance results due to offer­ing dif­fer­ences and com­par­ing results among the Swan prod­ucts and com­pos­ites may be of lim­it­ed use. All data used here­in; includ­ing the sta­tis­ti­cal infor­ma­tion, ver­i­fi­ca­tion and per­for­mance reports are avail­able upon request. The S&P 500 Index is a mar­ket cap weight­ed index of 500 wide­ly held stocks often used as a proxy for the over­all U.S. equi­ty mar­ket. Index­es are unman­aged and have no fees or expens­es. An invest­ment can­not be made direct­ly in an index. Swan’s invest­ments may con­sist of secu­ri­ties which vary sig­nif­i­cant­ly from those in the bench­mark index­es list­ed above and per­for­mance cal­cu­la­tion meth­ods may not be entire­ly com­pa­ra­ble. Accord­ing­ly, com­par­ing results shown to those of such index­es may be of lim­it­ed use. The adviser’s depen­dence on its DRS process and judg­ments about the attrac­tive­ness, val­ue and poten­tial appre­ci­a­tion of par­tic­u­lar ETFs and options in which the advis­er invests or writes may prove to be incor­rect and may not pro­duce the desired results. There is no guar­an­tee any invest­ment or the DRS will meet its objec­tives. All invest­ments involve the risk of poten­tial invest­ment loss­es as well as the poten­tial for invest­ment gains. Pri­or per­for­mance is not a guar­an­tee of future results and there can be no assur­ance, and investors should not assume, that future per­for­mance will be com­pa­ra­ble to past per­for­mance. All invest­ment strate­gies have the poten­tial for prof­it or loss. Fur­ther infor­ma­tion is avail­able upon request by con­tact­ing the com­pa­ny direct­ly at 970–382-8901 or www.swanglobalinvestments.com222-SGI-083017


By |2018-10-02T11:00:47+00:00August 30th, 2017|Blog|Comments Off on DRS vs. VIX Strategies — Strategy Comparison Series