Perhaps the greatest difference between a hedge fund and a traditional mutual fund is the use of volatility as an asset class. This is partly due to regulations preventing mutual funds from trading volatility as it is seen as complex and dangerous. This is quite understandable because volatility is a derivative product. It is actually a mathematical construct that measures the amount of fluctuation in the underlying security. In other words, it is not a real asset by itself.
However, as financial markets developed, volatility has become a very popular trading instrument. It started with the introduction of VIX futures. Then with the development in the ETF market, VIX ETFs were born. These ETFs are traded like stocks on the exchanges and so are easily accessible by retail investors. However, it does not take away the complexity and dangerous nature of volatility products.
Long Volatility Products are Designed to Lose Value Over Time
Take a look at the price chart of the most popular volatility ETF called VXX. This ETF is designed to provide exposure to a one-month constant maturity VIX futures contract or the one-month implied volatility of the S&P 500 index.
If you want a guaranteed way to lose all your money, just buy VXX and hold it forever. The reason why VXX decays over time is because of the specific nature of volatility. Implied volatility tends to be higher further out into the future. This is intuitive as it is more uncertain far into the future. So the typical term structure for VIX futures looks like this.
To replicate a constant one-month exposure to VIX, the issuer of VXX has to constantly sell the front month VIX futures contract as it nears maturity and roll over to the second-month VIX futures contract at a higher price. Hence, it is constantly selling low and buying high, incurring a high rolling cost. VXX price reflects this cost.
Well, if VXX decays over time, isn’t it a great candidate to short sell? Actually, there is another VIX ETF that allows you to do just that, the SVXY. This ETF does the opposite of VXX so if you want to short VXX, you just need to buy SVXY. This is where we look at the other side of the volatility beast.
Short Volatility Products are Vulnerable to Black Swans
Take a look at the historical price chart of SVXY, which in simple layman terms is an inverse VIX ETF. It is the opposite of VXX which we have seen above.
On 5th February 2018, the VIX experienced the largest one-day rise in its history, up 115%. SVXY lost 93% overnight because of this. This event prompted the issuer to permanently de-lever the exposure of SVXY to VIX by half with effect from 28th Feb 2018.
So choose your poison, do you want to lose your money slowly over time or do you want to lose it overnight?
Why Do Hedge Funds Still Trade Volatility?
Despite the grim prospects of trading volatility as presented above, if done properly, volatility is a very useful tool to add to a well-diversified portfolio. This is primarily due to its low correlation with other strategies and its ability to act as a potential hedge during a crisis. Below is the performance of our Volatility Risk Premium strategy which trades based on risk premium signals.
The strategy’s correlation with S&P 500 is only 0.04. In terms of performance, it is up about 60% in 2020. This is primarily due to a long volatility positioning during the peak of the COVID-19 market sell-off. It is up a further 19% so far in 2021, mostly due to short volatility positioning.
But I do not have the Expertise to Trade Volatility
Volatility indeed is the most complex and difficult to master of all the asset classes out there. It takes years of experience before a hedge fund manager can trade it successfully. However, gaining access to these hedge fund managers require either connections or large sums of money.
But we are breaking those barriers in our collaboration with iFAST Global Markets.
You can now build a portfolio using hedge fund-type strategies through iFAST Global Markets without lifting a finger. In this collaboration, we are combining AllQuant’s expertise in hedge funds and iFAST’s advisory capabilities and bringing it to your doorstep. All these are at a lower fee, lower investment minimum with zero lockups. Want to know how you can access such strategies as a retail investor?