In our last article, “Why Traditional Hedges Fail,” we opined that most traditional hedges had significant weaknesses and did not have many characteristics of a great hedge. Volatility (long positions in VIX futures), while not perfect, has a number of these favorable characteristics for hedging an equity portfolio.
The characteristics of an excellent equity hedge are three-fold:
- Makes more money in down markets that it loses in up markets; therefore, the hedge improves the risk adjusted returns of the portfolio. If the risk adjusted return is improved, the investor can either have less risk on the same investment size OR play more aggressive offense and have more profit for the same level of risk.
- Does not tie up large amounts of capital. Even if the hedge satisfies #1, if an investor must divert large amounts of capital to the hedge, the hedge is ineffective. If $200k of a $1M portfolio must be diverted to the hedge, then a +20% year for the S&P that results in a 5% loss in the hedge leaves the investor 50k worse off. Only 800k rather than 1M enjoyed the 20% rally, AND the hedge lost 10k. It’s not the loss that hurts; it’s the tied-up capital.
- Does not rely on magically predicting future market prices. If you are looking for market guessing schemes, you are reading the wrong article. The hedge can be managed, but it cannot rely on clairvoyance.
First, the weakness
Volatility is a derivative measuring the speed and size of equity market moves. While this can be a source of strength as a hedge, it is also its greatest weakness. Simply put, unlike a direct hedge (a put option or a short position), the S&P 500 can decline and decline a great deal without an effective volatility hedge, particularly in a slow grinding bear market.
Conversely, an investor with a put one year out 10% below the market is GUARANTEED a maximum loss of 10% plus the cost of the put (roughly 5-8%). An investor using volatility hedges does NOT have that same guaranteed maximum loss. However, it should not be surprising that maximum loss guarantees, just like in other forms of insurance, are quite expensive.
The Value of Long
This may sound strange, but one of, if not the most significant strength, is that volatility hedges are long volatility rather than short the S&P. This means that as the market drops, the VIX typically goes up. While the market is limited to the downside at zero, the VIX has no upper bounds. Our first criteria listed was that a great hedge will make more money in down markets than it loses in an up market. In addition, the VIX displays considerable “exponentially,” which is to say it can increase at an increasing rate (and the rate of that rate’s increase can increase). This “Exponentiality” allows for a small hedge to have potentially significant effects in times of crisis.
A benefit of this in practice is that a long position can compound intra-trade. If month one profits +20% and then month two repeats with another +20% gain, the second month yields 24% versus our starting value. A short position, such as a put, can actually “decompound,” meaning the rate at which it offsets loss will often slow down as the market drops. In month two in this example, the gain may only be 16% versus the starting point. When you have a long position hedging a decline, both sides work in your favor. By definition, the S&P can only drop 100%; however, the VIX can rally far more than 100%.
Capital Requirements—You can have your cake and hedge it, too.
Since the VIX primarily trades in futures markets, the capital requirements are quite friendly to a volatility hedger. If one holds the equity exposure and the hedge in futures, one could use $200k in cash to have $200k of S&P exposure and still hedge it for approximately $75k with margin to spare. Therefore, none of the equity exposure must be reallocated to the hedge. To repeat, you do not need to divert equity exposure to hedge, which satisfies goal number two on our list.
Cash and futures term structure
A cash and futures term structure can allow for effective timing WITHOUT guessing or predicting. In the case of the VIX, contract law is that the cash price and future contract value must be equal on expiration day. Therefore, when the curve is backwards, cash price > future, non-random situations present themselves. For example, if the cash is 35.00 and the future 25.00, then on an S&P decline, the long VIX future holder will make the cash VIX rally PLUS 1000 points or $10,000. Most of the time, an equity portfolio hedged with volatility will have small if any hedge protection (see weaknesses above), in which case the investor receives the market return.
The investing framework that decides when to add the VIX position is not “…there will be a market crash tomorrow …”. The decision-making process is, “…if there is a market crash tomorrow, this hedge will make far more than it will lose if the market rallies…” When you enter a volatility hedge, you don’t need to think the market is going down. The VIX term structure will tell you when to add a position and that IF the market goes down, you make the maximum amount.
Like many hedges, volatility can be adjusted to fit the risk tolerance of the individual investor. When examining “exponentiality,” term structure, and capital requirements, a strong argument can be made that volatility can be the centerpiece of an effective hedging strategy.
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