Preparing for Volatility Expansion in Investor Portfolios


Preparing for Volatility Expansion in Investor Portfolios


As advisors work to position client portfolios for market conditions which may lay ahead, a common question is how certain investments may perform in an expanding volatility environment—an important consideration given recent low levels of volatility—and historical patterns of reversion.

When looking at the long-term average of volatility, it’s widely accepted that volatility tends to exhibit mean reversion traits. Using the VIX, a volatility index that represents the market’s expectation of 30-day volatility, one can see these reversion tendencies.

Daily VIX Price
Daily VIX Price

At the time this article was written, only 3 days—out of 6,889 observed days of VIX prices—closed below the May 8, 2017 price of 9.77. Those days came during Christmas week in 1993. Following that time period, implied volatility expanded roughly over the next two and half years, taking the VIX above the long-term average where it would continue its upward climb before bouncing between 20 and 40 until 2004. After a period of compression, a similar pattern of expansion can be seen again from late 2006-2007 before the Financial Crisis pushed the VIX to all-time highs.

Since 2008, the trend has been primarily one of continued compression—minus a few pockets of volatility in 2010, 2011 and again in 2015. This trend has pushed the one-year average VIX to a level below that observed in 84% of all other rolling one-year periods.

It’s true that the very calculation of the VIX implies that volatility levels are likely to stay low for at least the near term, and predicting exactly when the expansion will start is futile. With that said, only in the financial markets do people equate variance with risk. According to Merriam-Webster, investment-related “risk” is defined as the chance that an investment (such as a stock or commodity) will lose value. And, often times it is after market risks manifest themselves through loss that volatility spikes. Luckily, the purpose of proper portfolio construction is not dependent on the exact timing of these events, but rather an intuitive mission statement that may go something like this: “To position portfolios in such a manner to give the investor the greatest chance of prudently growing capital in accordance with the investor’s goals and risk tolerances given a likely forward looking environment.” In this case, the likely forward looking environment is one of expanding volatility, thus the question that
started this piece is appropriate to examine.

How should low volatility strategies such as, 361 Long/Short Equity Strategy, perform in an expanding volatility environment?

361’s Long/Short Equity strategies, sub-advised by Analytic investors, pioneers of the research surrounding the low volatility anomaly, combine two return-generating ideas where they look at the investable universe through two separate lenses. One lens is solely focused on returns, while the other is solely focused on the stocks’ risk profiles by using predicted betas. After risk controls for individual holdings and constraints are applied, the portfolio is optimized on predicted risk and return characteristics. The portfolios can be expected to have a net exposure of 70% over time, but with a beta much below what might be assumed, given that exposure level. In fact, the strategies have both targeted and realized betas of between 0.4-0.6, while attempting to match the return of the market over time.

When examining equity markets across quintiles of volatility, assuming CAPM holds, one would expect the lowest volatility stocks to underperform the highest volatility stocks. However, that is not what has been observed over time. Indeed, there is actually a relatively flat payoff to risk quintiles using simple averages, and that payoff falls off as you move across the curve to higher volatility stocks once you take into account that impact that volatility has on compounding.

The reason this is important background is twofold. First, generally these portfolios look to be 100% long the lower volatility stocks of a given market and 30% short the highest volatility stocks (Net 70% with a targeted beta of 0.4-0.6). Second, there are specific timeframes when high volatility stocks do outperform low volatility stocks. Those timeframes are generally during periods of volatility compression, or more appropriately, compression of implied volatility (VIX) associated with “risk on” environments like that observed in the U.S. for most of 2016. Conversely, during periods of a market’s implied volatility expansion, high volatility stocks underperform, and at times significantly. The chart below examines domestic stocks and volatility using the VIX, and different quintiles of returns of the Russell 1000 grouped by volatility.

Periods of VIX Compression: Low Vol – High Vol*

The red arrows and corresponding numbers represent the low volatility minus high volatility spread during time periods of overall VIX compression, while the green arrows and corresponding numbers represent the same spread during time periods of VIX expansion. It’s clear that low volatility stocks have historically performed better than high volatility stocks during periods of volatility expansion. To represent this further, the graph below compares cumulative returns for both low and high volatility stocks during “extreme” time periods. Here the graph examines the run up of tech stocks and subsequent collapse, as well as the financial crisis.

Cumulative Return Low Volatility – High Volatility with VIX

This graph also demonstrates that when high volatility stocks vastly outperform low volatility stocks, it is during times of “risk on” environments that have historically been associated with a compressing VIX. Conversely, low volatility stocks outperform as investors seek relative safety during periods of fear and thus an environment with expanding VIX.


It is not likely that volatility will remain at these low levels and investors need to prepare for a return to something resembling normality at some point in the not too distant future (and when that occurs, it will likely blow through “average” if history is any guide). Given investing is a forward-looking exercise, this means investors need to be thinking about how portfolios will perform when volatility does normalize (i.e., how best to include investments that benefit from an expanding volatility environment). While past performance is not indicative of future results, 361’s Long/Short Equity strategies may perform well given the structure of the stock compilation generally being long low volatility stocks while maintaining a short position in the higher volatility stocks. If expanding VIX levels do in fact occur and the historical pattern holds, which seems likely given the desire for investors to move to “safer” investment in the face of uncertainty, this positioning should be favorable

The Cheapest Volatility

The VIX hit its lowest levels since 1993 this week, and that captured headlines. Whats most interesting to me is the spread between realized and implied volatility. Realized shows how much the market is actually moving, whereas implied is what the market thinks volatility will be.  During sudden shocks or crisis’ (BRExit) realized volatility can trade above realized. In normal markets realized is less than implied.

The chart below shows current implied (yellow line) vs realized (blue) in the SPY.  I like to think that (during “normal” markets) when the spread (the gap between the lines) narrows that volatility is “cheap”. For instance December in the chart below. In April there was major hedging of the French elections, so the IV spiked way up. The underlying market however didn’t budge.


Whats interesting about the current market is that realized volatility is essentially at historic lows. It could drift a bit lower, but its basically on life support. Implied volatility has really dropped after the French election as well, almost to the level of realized. So the situation is that realized is about as low as possible, but implied is right there with it. If they are both literally on the floor there are only two outcomes:

  1. Volatility continues to trade sideways
  2. Volatility gets up off the floor

I am not forecasting impending doom, I am just noting that it seems to me that the risk reward of shorting volatility is not as good as it was a few months ago. So, whether you’re long XIV, short VXX or in variance swaps I’d be cautious.

Remember – Volatility Mean Reverts

Its something everyone loves to say when the VIX is  at 20 or 30, heck even 15. Yesterday we hit lows in volatility not seen since 2007.

The spread between realized volatility (SPX realized is ~7) and 3 month SPX implied has come in quite a bit as per Bloomberg. In April realized was ~7 but implied was ~12. So from that standpoint, volatility is “cheaper” now than its been over the last few months.

Maybe its time to think about unwinding that short vol trade…

VIX lows

Remembering the “TVIX Fiasco”

History often rhymes – TVIX, VVX doesnt really rhyme but its close. Below is a very good review of what happened when TVIX broker and almost caused major problems for Credit Suisse.

As Volatility Turns: Understanding the TVIX Saga

Henry Chien, Formerly TG
02 March 2012

For many investors, all was well the week of Feb. 13 but anyone who peeked behind the scenes caught a glimpse of an episode worthy of its own award show in the financial world.

For many investors, all was well the week of Feb. 13 as the S&P 500 finally reached highs not seen since June 2008. The VIX dropped over the week by nearly 7 percent to finish at 17.78 that Friday as short-term volatility also receded. Yet anyone who peeked behind the scenes caught a firsthand look at an episode worthy of its own award show in the financial world.

Out of nowhere, the following week, on Feb. 22, Credit Suisse, the sponsor behind VelocityShares’ line of VIX exchange-traded products, temporarily suspended creation of shares in TVIX, a two-times levered short-term VIX ETP. According to a terse news release, the product’s assets had gone beyond the firm’s own internal trading limits. That was it. Except that the suspension electrified attention from market commentators.

So what happened? Well, the first forebodings occurred on Feb. 10 when notional vega volumes for TVIX over the day reached 52 million, an astounding increase of 128 percent from the previous day’s TVIX notional vega volume. Vega traded is the dollar exposure to the change in volatility. It disregards the notional price of the derivative contract. While somewhat odd, the VIX did spike 12 percent that day, which would indicate more the extreme skittishness on part of SPX option traders as the S&P 500 declined by 0.9 percent. High volumes in TVIX would be expected given the majority of its users are short-term speculators playing the index.


The following week – the week of Feb. 13 – another round of huge notional vega volumes in TVIX traded. Daily volume averaged 52 million each day, with a one-day peak of 72 million on Feb. 15. That compared with a five-day average daily 23 million in the prior week.

Authorized participants, who include market makers and HFT firms, have the ability to create new shares of TVIX to meet demand and ensure liquidity in the product. In the week of Feb. 13, total notional vega outstanding for TVIX notes jumped by 40 percent, or 17 million, to reach 60 million in just five days. As exchange-traded notes are unsecured debt securities, this number also indicates exposure from the point of view of the note issuer and the associated broker-dealer.

Keep in mind that under the ETN model, dealers are not limited to the VIX futures market and can hedge exposure via a variety of products. This feature is a plus given that liquidity flows across various products within the ecosystem of the S&P 500 volatility market. The caveat is end-user counter-party exposure.

Perfectly hedging that change in TVIX exposure over the week would require an equivalent 17 million in additional notional vega exposure, for the issuer, to rebalance the notes’ underlying holdings. That’s 3.4 million each day. The front-month VIX future traded a five-day average of 82 million per day in notional vega volume that week. Using these back-of-the-envelope calculations, a rebalancing of TVIX hedges would account for an estimated 4 percent of the front-month futures volume. This does not include the additional volume that would account for the daily rolling of the note.

While these numbers don’t seem like much, remember this is per point change in volatility – and in this case the corresponding VIX futures. This also does not take into account the market impact of this trading – an influence on the VIX futures price – that would make it tougher to cost effectively hedge.

During that Feb. 13 week, the front-month VIX future’s price rose, particularly on Feb. 15 when it jumped to 24.25, a 15 percent spike from the previous day. At the end of the week there was a 3.58 premium over the spot VIX, or 19 percent, and that premium remained elevated over the following week.


I’m not necessarily arguing a connection between the huge increase in TVIX vega volumes, the rebalancing to hedge the change in vega outstanding, or the spike in the underlying front-month VIX future. Rather, the confluence of the events all contributed to a perfect storm that made it difficult to manage exposure, which undoubtedly played a hand in Credit Suisse’s decision to suspend creation of TVIX notes.

In other words, I imagine a prudent trading manager took a look at TVIX liquidity, compared it with liquidity in the VIX futures market, assessed the desk’s position, and decided, ‘Whoah. Let’s back away from this. Better safe than sorry.” Further issuance of TVIX notes was then suspended.

One consequence was TVIX then effectively became a closed-end fund. With a cap on supply, TVIX began trading at a premium to its net asset value, the level of which has fluctuated since and remains in place today. The price of this premium is an additional market-determined element for TVIX that should be interesting to observe as it changes with differing levels of volatility.

While this episode has been great fodder for market commentators all around, there is a broader implication for industry participants. It demonstrates the limited direct arbitrage of VIX futures to the underlying spot VIX – and thus movements in the VIX futures market can be subject entirely to forces of supply and demand. While front-month VIX futures tend to trade at a slight premium to spot, the movements of the past few weeks highlights the potential for the contract to occasionally and temporarily move in a different direction than the underlying spot VIX. As more participants trade volatility directly, thereby broadening the variety of views on the direction of the VIX, it is likely this kind of action will happen again.

Surging liquidity in the VIX ETPs – which in turn has broadened access to volatility – is a key driver behind trading volumes in the VIX futures. Welcome to the new world of volatility as an asset class.

Paris Shooting

Police offers were just shot in Paris, 3 days before the election. Volatility sold off all day and the US market rallied as the latest polls gave Macron a better lead.

Paris Shooting
Paris Shooting

The French have no said who is responsible – but *if* its a terrorist (as in Islamic) attack will that substantially swing things? You’d have to think that this tilts things slight more toward Le Pen…

The close today might have been a great time to add some hedges as the markets could react sharply overnight on this.

Whats wrong with your Volatility Products (ETPs)

Many who trade in the volatility products (ETF’s and ETN’s etc) do not understand how the products work. If you don’t believe me just spend a few minutes on the Stocktwits VXX feed. Complaints usually relate to “the VIX moved and my [insert VXX, SVXY, TVIX, XIV, etc] didn’t move. This is market manipulation and or conspiracy.” There are dozens of articles about why these things don’t track the VIX, here’s one. What interest me is different.

Embedded in the prospectus of XIV is a clause that allows the ETP provider (Velocity Shares) to effectively terminate the leveraged product if there is “more than an 80% move” in the underlying futures. For leveraged products (i.e. 2x volatility) its only a 40% move. Note: this doesn’t specific DIRECTION it just says MOVE. So you could be correct in the direction (i.e. long XIV when volatility spikes) and still lose. I haven’t looked at other prospectuses, yet.

From the XIV prospectus (gotta love the term “Event Acceleration”):

“Sensitivity of the ETNs to large changes in the market price of the underlying futures contracts Because the Inverse ETNs and 2x Long ETNs are linked to the daily performance of the applicable underlying Index and include either inverse or leveraged exposure, changes in the market price of the underlying futures will have a greater likelihood of causing such ETNs to be worth zero than if such ETNs were not linked to the inverse or leveraged return of the applicable underlying Index. In particular, any significant increase in the market price of the underlying futures on any Index Business Day will result in a significant decrease in the Closing Indicative Value and Intraday Indicative Value of the Inverse ETNs, and any significant decrease in the market price of the underlying futures on any Index Business Day will result in a significant decrease in the Closing Indicative Value and Intraday Indicative Value of the 2x Long ETNs. If the price of the underlying futures contracts increases by more than 80% in a day, it is extremely likely that the Inverse ETNs will depreciate to an Intraday Indicative Value or Closing Indicative Value equal to or less than 20% of the prior day’s Closing Indicative Value and will be subject to acceleration if we choose to exercise our right to effect an Event Acceleration of the ETNs. If the price of the underlying futures contracts decreases by more than 40% in a day, it is extremely likely that the 2x Long ETNs will depreciate to an Intraday Indicative Value or Closing Indicative Value equal to or less than 20% of the prior day’s Closing Indicative Value and will be subject to acceleration. If the price of the underlying futures contracts decreases by more than 80% in a day, it is extremely likely that the Long ETNs will depreciate to an Intraday Indicative Value or Closing Indicative Value equal to or less than 20% of the prior day’s Closing Indicative Value and will be subject to acceleration if we choose to exercise our right to effect an Event Acceleration of the ETNs”

Several years ago there was a class action lawsuit against Credit Suisse due to the rapid decay in their TVIX product.


Feb 2012:

“Credit Suisse, the sponsor behind the VelocityShares Daily 2X VIX Short-Term ETN (NYSEArca: TVIX), temporarily suspended creations of shares of the exchange-traded note because assets in the security had grown beyond what the bank, in a press release, called “internal limits.”

This all plays into a future event I see coming which I’ve dubbed “volivator”.

My point is this:

Know what you’re trading – if you don’t understand it then you have no business trading it.