The CBOE Volatility Index more than tripled during the course of trading on August 24, 2015 – an all-time record. On that same day, the S&P 500 fell nearly 4%, while the Barclays U.S. Aggregate Bond Index gained a miniscule 0.03%, demonstrating the ineffectiveness of the standard two asset class portfolio diversification model. Puny bond yields provide little cushion for broad market selloffs, which has led many investors to turn to alternative strategies and asset classes, including volatility itself. This is the subject of a new white paper from Allianz Global Investors (“Allianz GI”): Volatility as an Asset Class.
Volatility: Realized vs. Implied
The paper’s author, Dr. Bernhard Brunner, is Allianz GI’s Head of Analytics and Derivative. He begins by discussing the difference between realized volatility – the standard deviation of logarithmized returns; and implied volatility – that which is measured by the CBOE Volatility Index (VIX). Realized volatility is typically less than implied volatility, and this means buying implied volatility, such as through VIX futures, comes with a volatility risk premium. Thus, while the negative correlation between equities and equity volatility makes buying implied volatility seem like a good portfolio diversifier, the consistent volatility risk premium makes it even more attractive to sell volatility, according to Dr. Brunner.
In addition to taking short positions in VIX futures or ETPs that track volatility, investors can also sell volatility through so-called variance swaps. Variance swaps are traded “OTC” (“over the counter”), but swaps on equity indexes such as the S&P 500 and EuroStoxx 50 are highly liquid nonetheless. And while VIX futures may have considerable variance from realized volatility, variance swaps can be structured so their payoff is exactly equal to the difference between realized and implied variances, thereby constituting a more precise definition of the volatility risk premium.
Allianz GI’s Approach
Allianz GI has developed an index to earn the volatility risk premium by systematically selling variance swaps on the S&P 500 and EuroStoxx 50. Its investment approach is governed by specific rules and based on the following characteristics of volatility as an asset class:
(1) Volatility always reverts to its long-term mean;
(2) Volatility tends to bounce briefly when the stock market slumps, followed by lengthier downward trends; and
(3) Volatility forms volatility clusters.
Volatility offers a lot of promise as an asset class, based on its portfolio-diversification advantages. Most notably, volatility has what Dr. Brunner describes as an “immunity to interest trends,” which makes it virtually unique among investible assets, and particularly attractive in the current investment environment.
For more information, download a pdf copy of the white paper.