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- How all common asset classes had weak performance at the same time in March 2020 due to the Coronavirus crisis.
- That the only asset class actually performing well in that time was VIX ETFs.
- What the VIX is and how you can use it as an insurance policy in your portfolio to protect against volatility, uncertainty and black swans events.
- How including only 3% of a VIX ETF in a risk balanced portfolio increased return, lowered volatility and increased the Sharpe ratio of an example All Seasons Portfolio. This is shown with an extensive case study through first half of 2020 and the 30 month period leading up to 30 June 2020.
- All raw data on which the analysis, graphs and tables in this article is based on, are exclusively found in the Patreon version of this post. Support the blog to get access.
- I will update my portfolio to include 3% VIX.
- Book Tip: The VIX Trader’s Handbook (published October 2020) by Russel Rhoads (link at the end of the article).
All assets under-performed in late March.
Do you still remember how different asset classes performed amidst the most urgent phases of the coronavirus crisis? Or have you intentionally suppressed those bad memories and only chosen to remember the recovery in assets such as stocks?
As a reminder, there was period in early 2020 from about March 10th to March 20th when every major asset class declined in value at the same time, regardless if they were biased to perform well in increasing or decreasing economic growth environments. Stocks and commodities had already fallen by then, but by March 10th, also gold, treasury bonds and inflation-linked bonds fell as well. Nothing managed to offset the declines in growth assets, and any balanced portfolio suffered.
While a risk parity strategy, such as the All Seasons Portfolio strategy, performed much better than the stock market or a traditional 60/40 portfolio, the Covid-19 crisis caused a dent also in the All Seasons Portfolio. The All Seasons Portfolio even turned into negative territory on a YTD basis, even though it recovered rather quickly from that temporary dip.
Too high portfolio volatility is not considered to be an attractive trait of any portfolio. The March performance of major asset classes thus begs the question whether there was any way that a dip could have been avoided?
Sure, you could have bought an inverted S&P 500 ETP or certificate, but that is hardly an effective way of decreasing the volatility of a portfolio over time, while still collecting risk premiums (you would have just always eliminated stock gains but added counter-party risk into your portfolio).
But as a matter of fact, there was one index that actually made a killing in March, and even is available for any retail investor to include in a diversified portfolio to lower the volatility, and thus improving your risk-adjusted return.
That index is the VIX, i.e. the Volatility Index (or the “Fear Index”) posted by CBOE, which measures forward-looking volatility of the S&P 500. We will look at VIX in more detail immediately below.
But how can you invest in a gauge that tracks the volatility of the stock market? There is of course futures contracts tracking this index, and anyone can get access to such futures contracts by investing in VIX ETFs. Such VIX ETFs have been among the best performing ETFs in 2020 (per November 2020), as ranked by JustETF when sorted by 1Y performance.
In this article, we will be more closely looking at the Lyxor S&P 500 VIX Futures Enhanced Roll UCITS ETF – Acc, and how the VIX can be used as an insurance for your portfolio against sudden market volatility and financial crises. We will especially be looking at how it would have helped your portfolio perform much better through the most acute phases of the Covid-19 coronavirus crisis in March 2020.
What is VIX?
Let’s take a step back. Before we proceed, it is wise to first understand what VIX is.
The VIX is an index created by CBOE (Chicago Board of Exchange) to track market volatility. It is generated from implied (forward-looking) volatilities from prices on index options on the S&P 500, and thus is intended to reflect the market’s expectations of 30-day volatility. It is also famously known as the “Fear index” or “Fear gauge”, as it is commonly used as a measurement of how eager investors are to hedge against losses during uncertain and volatile times.
Translated into simpler terms, this means that the VIX tracks the forward-looking volatility of the S&P 500 from an aggregate weighted basket of put and call options on the S&P 500 index of a wider range of strike prices and with an expiry of between 23 and 37 days. The bid and ask prices of these options represents the market perception on the probability of the strike price of that option to be reached by the underlying stocks within the remaining time to expiry.
In practical terms, when the market is in an uncertain state, put (sell) options with strike prices further below from the current trading price will be traded at higher prices, as market participants seek to hedge their market exposure. The market perception will in such a situation be that it is increasingly likely that the future price for the underlying assets (the S&P 500 in this case) will be lower than where it is trading today. The further away from the current price of the underlying asset that these options are trading, the higher the implied (forward-looking) volatility is, and thus the higher the CBOE Volatility Index will rise.
VIX thus measures how much investors are willing to pay to buy or sell the S&P 500. In absolute terms, VIX values above 30 are generally linked to large volatility from increased uncertainty, risk and investors’ fear. Values below 20 are typically considered to indicate stress-free periods in the market.
How can VIX be used in a portfolio to decrease portfolio volatility?
As mentioned above VIX is a measure of volatility (the Volatility Index). This means that a product tracking the VIX, such as VIX options, VIX futures or a VIX ETF, will decrease in value when volatility is low and increase in value when volatility is high. In this article, we will focus on hedging a portfolio using a VIX ETF.
The VIX itself will, during times of low volatility, stay at a close range of value, but the VIX ETF itself will decay due to the behavior of the VIX futures curve when the futures held by the ETF is rolled into subsequent futures contracts. But when volatility increases, the VIX futures will increase in price, pushing up the value of a VIX ETF.
A VIX ETF is therefore a handy insurance policy for when the volatility expectations for the next 30 days increase, and when the market is in the middle of a period of increased volatility and uncertainty. During such periods, the stock markets is likely to dip (although volatility is a measure that goes both ways, not only on the downside), and under extreme conditions, most other assets may decline as well. Then a wide-spread risk-off sentiment will roll over the market, dragging all assets down, and the VIX to spike.
As VIX will move in inverse of the stock market in uncertain times and during rare negative events, you can use it as an insurance policy for tail risk.
Just like any insurance policy, when it is not needed, you will be seeing a constant negative result until you need to cash in on the insurance. Your home insurance works the same way. You pay premiums to your insurance company for every month there is no fire or water leak, but when one such event occurs, the insurance provider will be making you a payment well in excess of all premiums you have paid over the years.
The same goes for VIX. Over times of stable growth, the VIX will be stable at a low level (10-20 on a scale to 100). However, as a VIX ETF tracks VIX futures contracts, a small loss will be made each time the contracts are rolled, meaning that the value of the ETF will slowly be drained.
Hence, to protect against rare events, times of high volatility and uncertainty, and black swans, you can opt for including VIX ETFs for a small part of your portfolio. Sure, for the years nothing happens, it will drag down your total performance. But when volatility spikes, the VIX ETF will pay you back your premiums, and awarding you with a more stable development, lower portfolio drawdowns, and better risk-adjusted return (higher Sharpe ratio).
You could therefore consider to include a small amount of VIX ETFs in your portfolio. For example 3% of your portfolio value at all times, to ensure you are protected against the unforeseen negative events.
For European investors one such ETF available is the Lyxor S&P 500 VIX Futures Enhanced Roll Ucits ETF (ticker: VOOL (Xetra) or LVO (Euronext/Borsa Italiana)). During the spring of 2020, its YTD performance was staggering, having increased by 294% YTD by 18 March 2020 from 3.41 on January 1st to €13.11. Granted, until the Covid-19 crisis hit, its value was slowly eroding down to a low posting of €3.08 on February 17th. But regardless, if you would have held this ETF in your portfolio when all hell broke loose, it would have offset much of the declines in other assets, even if you would have only had 3% of your portfolio allocated to it. And with a VIX ETF only making up 3% of our portfolio, the continuous drainage will have rather limited effect on your total wealth.
To show case the difference that a VIX ETF would have made for an All Seasons Portfolio through the first half of 2020, in the next segment, we will look into a case study comparing two very similar All Seasons Portfolios, with the only difference that we include a VIX ETF that makes up 3% of the portfolio.
Case study of VIX in practice for an All Seasons Portfolio
To make the concepts more understandable and easier to take in, we will spend most of the remainder of this article with a detailed view of portfolio comparisons, together with a bunch of graphs to help visualize what a VIX ETF can do for you portfolio.
In this example, we will be using an All Seasons Portfolio with American geographical focus and without currency hedging. We will examine the portfolio and compare it against an almost identical portfolio, where the only difference is that we have included a VIX ETF that takes up 3% of the portfolio. We have also decreased long-term bonds and TIPS by a total of 3%.
The reasons for this is that VIX is a negative-growth asset, but inflation neutral, why we have decreased assets that do well when growth declines, and have adjusted on assets that both perform better and worse when inflation rises and falls, respectively.
All in all, our two portfolios look like this:
|American All Seasons Portfolio||Type||ISIN||Ticker (Xetra)||Allocation|
|iShares USD TIPS UCITS ETF||TIPS||IE00B1FZSC47||IUST||15%|
|iShares $ Treasury Bond 20+yr UCITS ETF||Long-Term Bonds||IE00BSKRJZ44||IS04||40%|
|Vanguard S&P 500 UCITS ETF||Stocks||IE00B3XXRP09||VUSA||30%|
|iShares Diversified Commodity Swap UCITS ETF||Commodities||DE000A0S9GB0||SXRS||7.5%|
|American All Seasons Portfolio with VIX||Type||ISIN||Ticker (Xetra)||Allocation|
|iShares USD TIPS UCITS ETF||TIPS||IE00B1FZSC47||IUST||14%|
|iShares $ Treasury Bond 20+yr UCITS ETF||Long-Term Bonds||IE00BSKRJZ44||IS04||38%|
|Vanguard S&P 500 UCITS ETF||Stocks||IE00B3XXRP09||VUSA||30%|
|iShares Diversified Commodity Swap UCITS ETF||Commodities||DE000A0S9GB0||SXRS||7.5%|
|Lyxor S&P 500 VIX Futures Enhanced Roll UCITS ETF - Acc||VIX||LU0832435464||VOOL||3%|
Before we will dive into a number of graphs, let us take a brief moment to examine the performance summary of both portfolios for the first half of 2020. We have mainly assumed annual rebalancing of the portfolio, so the splits in the table above are per 1 January 2020, and no rebalancings are made during the course of the year. However, where explicitly mentioned, we have also compared performance with quarterly rebalancing.
As you note, the Return YTD was much better when including the VIX ETF, even though it only constituted 3% of the portfolio by the beginning of the year. By end of June, the example portfolio with VIX has achieved more than 10% growth, even without leverage.
Moreover, the stability of the portfolio with VIX was better. This you can see from the lower volatility, much better Sharpe ratio, and lower Max Drawdown (from previous top to next bottom). At all times over the year, the portfolio with the VIX ETF stayed positive (0.32% at worst), while the portfolio without the VIX ETF had declined to 5.49% by 18 March 2020.
|Key data as per 2020-06-30||American All Seasons Portfolio||American All Seasons Portfolio with VIX|
|Std Dev / Volatility||1.06%||0.91%|
|Worst YTD result||-5.49%||0.32%|
|Performance of 50k||€53,583.74||€55,264.96|
|Performance of 50k with quarterly rebalancing on 31 March||€54,203.12||€56,132.38|
|Risk free rate:||0.66%|
|10yr US Treasury yield 30.06.2020|
Translating the table into a graph, you can see rather clearly how the VIX ETF helped strengthen portfolio performance and stabilize returns. The red line here below had a much more shallow dip through March 10th to 20th than a portfolio where the VIX component was not used.
The red line shows the performance of the portfolio with the VIX ETF, and even though it lagged slightly or the first two months of the year (the “paid insurance premiums”), when the coronavirus crisis hit the markets in early March, the performance was much better than the portfolio without exposure to VIX. The difference in performance then remained for the rest of the comparison period.
If we break the performance down to asset per asset level, it becomes very clear how VIX was the only asset with positive performance in the middle of March. The VIX ETF is the light blue line on the graph to the right.
But because the VIX ETF only constituted a small part of the portfolio, the above graphs do not give a fair view of each assets contribution to the total portfolio’s performance. Instead, look at the next set of comparative graphs, where the daily development of each asset class/ETF has been adjusted with each ETF’s share of the portfolio on that day (the weight-adjusted contribution to performance).
The spike for the VIX ETF is still considerable, but a bit more modest than when shown on its own. When comparing the two graphs, and especially the black lines which shows total portfolio performance, it becomes very evident how the VIX ETF helped offset the declines in all other asset classes to decrease the negative impact that the Covid-19 shock had to the markets.
What about rebalancing? So far, we have only compared portfolios with annual rebalancing. Often, it is enough that you rebalance your All Seasons Portfolio once per year, but some may prefer to rebalance a bit more often.
Here below is a graph showing the same two portfolios that have been discussed in this article, with the only difference that a rebalancing was made on 31 March 2020 (lines in green and yellow). As you will see, it had a positive impact this time on portfolio performance, although that may not always be the case.
What about longer-term impact of VIX ETFs?
As I already mentioned earlier in this article, when you hold a VIX ETF, until something happens that triggers great volatility, the value of that ETF will slowly be eroding away. These are your paid insurance premiums.
In the previous segment, we have only discussed how the VIX ETF helped through a crisis and we only looked at two quarters in 2020. Let us therefore zoom out a bit to see if we can see how the same portfolios would manage over a slightly longer period of time.
Unfortunately, I was only able to easily find data of all ETFs from January 2018 (as I have used Google Finance for this exercise). Hence even our backtesting will not be 100% accurate as it only covers 2.5 years, but at least it is much better than trying to draw any conclusions from a 6-month period.
The premises for this exercise are the same as what we did for the H1 2020 analysis above. We use the same portfolios and unless anything on the contrary is stated, the portfolios are rebalanced annually by end of year.
The development of both portfolios is rather similar. The portfolio including the VIX ETF amounting to 3% of the portfolio value on rebalancing (red line below), only slightly lags the normal All Seasons Portfolio until volatility on the markets increases. Over the selected time period, there were mainly two such events: by end of 2018 with the general market jitters, and by beginning of 2020 with the Covid-19 crisis, which we covered above. Over this period, the VIX portfolio outperformed regular All Seasons Portfolio, albeit very slightly.
Below is the table with key info over the longer-term performance of the same All Seasons Portfolio with American exposure and without currency hedging as described earlier in this article. Over the 2.5-year period, the performance is excellent and stable, despite the market having been unstable on several occasions over the period (Brexit, trade wars, Iran, Covid-19, etc.). A CAGR of 10.24% and 11.47% respectively for the portfolios without and with a VIX ETF is a great annual result for what is typically understood as a defensive strategy.
|Key data 2018-01-01 to 2020-06-30||American All Seasons Portfolio||American All Seasons Portfolio with VIX|
|Std Dev / Volatility||1.34%||1.17%|
|Performance of 50k with annual rebalancing||€63,803.59||€65,595.86|
|Performance of 50k with quarterly rebalancing||€64,986.44||€64,564.45|
|Risk free rate:||0.66%|
|10yr US Treasury yield 30.06.2020|
We continue below with each asset’s performance over the 30-month period until 30 June 2020. This is an interesting chart, showcasing how each major asset class has performed the last few years. Only toward the end, growth assets have slumped, but commodities have never managed to reach much below the starting point. While the graph on the right with VIX is more stable, it has not only to do with the zoom level, but to some extent also to the VIX ETF, offsetting the falls in markets on three occasions.
Here you can also compare the All Seasons Portfolio’s development against the S&P 500 by comparing the black and yellow lines. Both with and without VIX, a risk parity strategy has been superior to stocks after the Covid-19 market crash.
In the next sets of graphs, you will find each asset’s/ETF’s weight-adjusted contribution to the overall performance per day of the All Seasons Portfolio without and with a VIX ETF. On occasion, you can see (if you zoom in) that the VIX ETF on occasion contributes negatively to the performance between spikes, and then jumps back into positive territory during uncertain times – most noticeably in the beginning of 2020 when the VIX index hit record-high levels of around 86 of a scale from 0 to 100.
Lastly, let us take a brief look at what difference it would make to increase the times per year you rebalance the portfolio from annually to quarterly. Again, as you see, the difference is negligible. Apparently, regardless how often you rebalance, it will be better than if you buy once and then totally forget about your portfolio (red and blue lines are a portfolio without any rebalancing since 1 January 2018).
Conclusions and summary
So, what conclusions can we draw from the above analysis of the short and longer-term impacts of including VIX in your risk parity portfolio?
First of all, from a general standpoint, we have seen that an All Seasons Portfolio strategy is a good option when seeking stability but without conceding returns. This at least holds true for the analyzed portfolio built by assets with American exposure.
The VIX ETF has provided even increased stability into the portfolio with better return, lower volatility and, thus consequently, better Sharpe ratio. Through first half of 2020, the Sharpe ratio (measuring risk-adjusted return) rose from 6.15 to 11.6 when including VIX in our All Seasons Portfolio. The corresponding number for the longer term (30 months until end of Q2 2020) was an increase from 20.1 to 26.65. The VIX ETF we have used in this example is the Lyxor S&P 500 VIX Futures Enhanced Roll UCITS ETF – Acc (ticker VOOL on Xetra and LVO on Borsa Italiana and Euronext Amsterdam), which has made up 3% of the example portfolio.
If you invest in a VIX ETF, during times of low volatility and higher market stability, the value of the ETF will steadily be eroded. However, if you only hold a small portion of your portfolio in this asset class, the total impact on your portfolio performance will be limited. And when an unpredicted or mispriced event occurs, such as the Covid-19 crisis, the VIX ETF – your insurance policy – will repay you and offset losses in your other held assets.
While we have here only examined an American portfolio, European and global stocks have fared even worse in the latest crisis. In such portfolios, a VIX ETF would have played an even more important role, if European/global government bonds would not have been able to alone offset losses in stocks.
Based on the findings described in this article, I have decided to include 3% VIX ETF in my All Seasons Portfolio to decrease volatility and improving the risk-adjusted return. My aimed portfolio allocation will going forward be updated as shown in the pie chart below.
Do you already use VIX actively as part of your investment strategy, or do you consider using it, or any other asset class for that matter, as an insurance against tail risk and unpredictable market environments? I would love to hear your thoughts and reflections in the comment section below, and look forward to great and intriguing discussions.
Thank you so much for your attention and your time!
Best wishes and until next time,
Book tip: The VIX Trader’s Handbook: The history, patterns, and strategies every volatility trader needs to know (October 2020) by Russel Rhoads
If you want to learn more about how you can use VIX to your advantage as part of your investment strategy, I warmly recommend this great and comprehensive book on VIX trading by Russel Rhoads. It is fresh from the prints, and published as recently as October 2020, so the information is very up to date.
Russell Rhoads is one of America’s leading experts on VIX, the Volatility Index. In The VIX Trader’s Handbook he takes a deep dive into all things associated with volatility indexes and related trading vehicles. The handbook begins with an explanation of what VIX is, how it is calculated, and why it behaves the way it does in various market environments.
It also explains the various methods of getting exposure to volatility through listed markets. The focus then moves on to demonstrate how traders take advantage of various scenarios using futures, options, or ETPs linked to the performance of VIX. Finally, a comprehensive review is presented of volatility events that shook the markets, including the 1987 crash, Great Financial Crisis, 2010 flash crash, and the 2020 pandemic.
By understanding how VIX behaved leading up to these market shocks, and reacted afterwards, traders can better equip themselves ahead of future events. A wide variety of strategies that are implemented in both bearish and bullish equity markets are introduced and covered extensively throughout.
The VIX Trader’s Handbook is essential reading for all those who are intending to trade volatility―from those who wish to gain an understanding of how VIX and the related trading products behave, to those intending to hedge equity exposure or take advantage of the persistent overpricing of option volatility.
You won’t want to trade volatility without having read this book.
For anyone interested in the All Seasons Portfolio and Risk Parity investing, I find this a great read as you enhance your understanding for both the vulnerabilities of the economies (ref. discussion above on credit ratings) and government bonds.Or check out other great books on the topic on the Book recommendation page.
Note that we have used American portfolio in the examples. Exposure to other regions, currencies and other ETFs may vary. Historic performance does not guarantee future returns. In this article, I have not covered Inversed VIX ETFs, which you should be very careful to use as losses may be high and should not be held for longer periods of time. VIX ETFs are a risky asset class, but when traded carefully, they can prove to be lucrative. Nothing in this article shall in any way be considered to be an investment recommendation, and is provided for entertainment purposes.