Yesterday, we gave a brief recap of the VIX futures overview given by Russel Rhoads of the CBOE at our event last week. But that was just half the fun. We also had four professional hedge fund managers (technically, commodity trading advisors since these are VIX futures) talk to the crowd about how they view volatility as an investment opportunity, not just a fear gauge. The members of our panel 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.
We had a a great discussion on the ins and outs of VIX futures, and here’s a brief recap:
Is VIX a hedge or an alpha generator?
While most of the literature and use case for VIX futures is as way 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, with the caveat that it depends greatly on the market environment to know where that alpha might be coming from (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, and VIX futures as a hedge on that alpha, while noting that the greater investing public likely views it as a way to hedge your portfolio, or as “insurance” in your portfolio.
Brett Nelson, of Certeza was a little more bold and adventurous, standing the question on its head and asking the audience to think of the S&P 500 as a hedge of the VIX, not the other way around.
Are the infamous VIX spikes cause for alarm, or joy, for your program?
The general consensus on spikes in the VIX was that they can be scary while happening, 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 welcomes these spikes but that we all must “respect them” or there’s a possibility of recording major loses.
But each panelist mentioned that the spikes can be joy inducing shortly after the fear phase – as the spikes typically represent over buying and over protection by other market participants. That overbuying can cause market inefficiencies which their programs can 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, pairing the VIX futures with the S&P 500 – the index underlying the options index underlying the VIX. This strategy calculates whether implied volatility is ‘cheap’ or ‘expensive’ relative to current realized volatility, and puts on a hedged trade of sorts where they try and isolate just the overbought/oversold aspect of the pricing, while eliminating the directional risk of the trade. This manifests itself with the program either being long/short, short/long, long/long, or short/short – as in short VIX / short Emini-S&P or Long VIX / Long Emini.
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 as the current volatility environment and where/how that environment might shift looking out into 2017 and beyond.
There was the usual comments about the Fed put, central bank intervention artificially suppressing volatility, and the rest – but with a different tone than we usually hear when discussing these matters – as that sort of suppression is not necessarily a bad thing for these managers investment programs. While many systematic managers complain about 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 volatity can be greater than they otherwise might be coming from such depressed levels). From there, it was 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.
This topic got a question from the crowd on whether this unpredictable presidential campaign might lead to a very unpredictable (and therefore market volatile) election day/week/month; to which the panel generally answered no, because that information is already priced into the market. It’s already known who the candidates are and that one of them is a little unorthodox.
Tim Jacobson had a great talking point here, saying to think of the VIX like a radar screen – where all of the known information the market has is reflected on the screen in various blips and dots. The rough some of all that information results in the current VIX level. He continued along the lines of 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 a asset allocation?
This may have been a better question for a panel of asset allocators and investors, not the proprietors of the very investment we’re asking about – but the answers were interesting nonetheless. After the standard disclaimers by the panel that they don’t know the specifics of each investors 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 its 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 – allowing 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 full presentation from the event, email us at [email protected]