![[Un]Expected Return](https://substackcdn.com/image/fetch/$s_!hfmC!,w_80,h_80,c_fill,f_webp,q_auto:good,fl_progressive:steep,g_auto/https%3A%2F%2Fbucketeer-e05bbc84-baa3-437e-9518-adb32be77984.s3.amazonaws.com%2Fpublic%2Fimages%2F8a685762-6cbb-4120-ad47-905ff7e7db6d_1280x1280.png)
![[Un]Expected Return](https://substackcdn.com/image/fetch/$s_!hfmC!,w_36,h_36,c_fill,f_webp,q_auto:good,fl_progressive:steep,g_auto/https%3A%2F%2Fbucketeer-e05bbc84-baa3-437e-9518-adb32be77984.s3.amazonaws.com%2Fpublic%2Fimages%2F8a685762-6cbb-4120-ad47-905ff7e7db6d_1280x1280.png)
Portfolio hedging through the VXX
How to deal with the limits of naive diversification
Dear Readers,
in the last post I showed why the traditional concept of diversification is more of an illusion than a reality.
Indeed, we saw that during periods of serious market turmoil and unlike normal times, a simple long portfolio of traditional assets (like stocks, bonds, gold and even cryptocurrencies) loses the ability to “smooth” its returns by following a coveted “diversification law”, because all the assets plummet at the same time.
Let’s show again what happened during the last March 2020 crash:
In order to see more clearly the “non-diversification” feature, I built a virtual portfolio between April 2018 and October 2020, exposed to the five components you see in the previous chart, with the following weights:
Equity All World: 40%
Equity Emerging Markets: 10%
Gold ETF: 20%
U.S. Treasury Bond ETF: 20%
BGCI Crypto Index: 10%
The portfolio makes a daily rebalancing and I didn’t take into account the trading costs (so the equity line is always higher than the “real trading” one):
You can notice two large drawdowns, the latter representing the March 2020 crash.
One possible way to overcome this “lack of diversification” is to be exposed to something that goes up during the stock market turmoil, by assigning it a certain non-large weight.
The rationale is something like this: most of the portfolio should be invested in assets that have a positive expected CAGR, and a small part of the portfolio should be invested in something that has a negative expected CAGR (you have to pay for the insurance component) but that has a positive performance in the delimited period in which the stock market plummets.
But… wait a moment… how can the portfolio “gain” by including an asset that loses money in the long term?
One step at a time…
VIX, VIX futures and VXX
The CBOE Volatility Index, known as VIX, measures the expected volatility of the S&P 500 Index (SPX) for the next 30 days (annualized).
More precisely, the VIX represents the implied volatility of the SPX, computed through the SPX options prices (both put and call options).
This is the formal definition, but there is a more intuitive definition for the VIX index:
The VIX measures the market sentiment towards the level of uncertainty of the stock market in the short term (one month).
Historically, the VIX and the SPX move in the same direction only 20% of the time: 80% of the time instead, when the SPX has a negative (positive) return the VIX has a positive (negative) return.
This inverse relationship between VIX and SPX exists because the VIX can be thought of as a measure of increased demand for SPX options (more demand -> higher prices -> higher implied volatility) and that demand is often more aggressive for put options rathen than call options.
Implied volatility goes up when there is strong demand for options, and this typically happens during declines in the price of the S&P 500 (SPX) as market participants (who are collectively bullish) are quick to buy protection (put options) for their portfolios.
When the S&P 500 rallies instead, we see demand for protection dissipate and as a result a decline in the VIX.
Unfortunately though, it is not possible to buy or sell the VIX directly.
Even the VIX options are not based on the price of the spot VIX.
Instead, the underlying asset is the expected value of the VIX at expiration.
In other words, the value of VIX options is more closely correlated with VIX futures than the real-time VIX.
While technically not the actual underlying, VIX futures act as if they were the underlying for VIX options, i.e. the options prices do not closely track the VIX.
Introduced in 2004 on Cboe Futures Exchange (CFE), VIX futures contracts provide market participants with the ability to trade a liquid volatility product based on the VIX Index methodology.
VIX futures contracts reflect the market's estimate of the value of the VIX Index on various expiration dates in the future and their contract size is $1000 times VIX.
So for example if the VIX futures quote is 20, one VIX futures contract is worth $20,000.
The VIX futures curve is usually in contango: this means that in a given day, the futures with a more distant expiration date have a higher price than the futures closer to the current day.
Let’s see the VIX futures term structure of today, April 9th 2021:
When the term structure is in contango we have a problem: value decays over time. Most days VIX futures drift lower relative to the VIX: this is because when we buy a futures contract we spend more money compared to the money we receive when we sell it in order to roll the position forward, ceteris paribus.
Stay with me, I am going to explain this concept with a practical example.
Let’s suppose that today we go long on one VIX futures contract with expiration in June 2021: the price is 22.175 as you can see in the chart above (for a contract size of $22,175).
When we arrive in June we have to sell this futures contract and buy another futures contract with the same maturity (i.e., rolling the position by selling the futures contract we have in portfolio that is near to the expiration date and by buying a new VIX futures with expiration in August 2021: in this way we can maintain a long position on the VIX futures in a continuative mode).
But if the futures term structure in June 2021 is the same as today (i.e., the same contango structure), we will receive less than $22,175, ceteris paribus.
This is because when we will be in June 2021, the June VIX Futures corresponds to the current April VIX Futures, and so, ceteris paribus, we’ll receive $18,125 by selling it, obtaining a negative roll yield.
In other words, a long-term exposure on the VIX Index through the long rolling of VIX futures results in a negative CAGR.
Similar considerations apply to the VXX, a VIX Index derivative-product.
This product is an Exchange-Traded Note (ETN) created in 2009 by Barclays to offer exposure to the VIX Index; this product trades like a stock even if it has very different features compared to a stock or even compared to an Exchange-Traded Fund (ETF).
Indeed, unlike ETFs, ETNs are unsecured debt subject to the issuer's credit risk.
So the VXX represents a more accessible investment vehicle compared to the VIX futures (you don’t have to deal with the rolling procedure, the fund manager will do it for you), but the “cost” the investor has to pay for this facilitation is represented by a certain level of credit risk.
Ideally, VXX would track the CBOE’s VIX index—the market’s de facto volatility indicator. However, since, as we already said, there are no investments available that directly track the VIX, Barclays chose to track the next best choice: VIX futures.
In fact, the VXX’s underlying is the S&P 500 VIX Short-Term Futures Index Total Return.
Hence, the same problem of value decay (caused by a term structure in contango) that afflicts VIX futures, afflicts the VXX as well.
In other words, in the long term you will lose money by investing in the VXX.
A picture is worth a thousand words , so let’s see below both the SPX and the VXX in the last 5 years:
In the last 5 years the VXX has lost 96% of its value, while the SPX’s performance has been + 98%.
Actually, many analysts define this product “toxic”: since VXX decays heavily over time due to contango and it does not generally make for an efficient long-term trading vehicle, they claim that VXX should only be traded short term and/or should be shorted after spikes in volatility in order to exploit its mean reversion behaviour.
This is absolutely true if we considered the VXX as a single investment.
But this is not necessarily true any more if we inserted the VXX in a portfolio that has a positive expected CAGR in the long term but that suffers big losses during market turmoils.In fact, you can see that during the stock market crash of March 2020 (when the orange line plummets) the blue line climbs up.
In order to show why the VXX is not necessarily “toxic”, I built the same portfolio of the previous example, for the same period, with only one difference:
the only difference is that I removed a weight of 10% of U.S. government bonds in order to add a weight of 10% of VXX.
Let’s see the result:
You can notice that both drawdowns are now smaller.
In particular, during the March 2020 crash, this porfolio had a drawdown of only 11.6%, instead of the 22.7% of the portfolio without the VXX.
You can also notice that the final values of the two portfolios are very close: this means that we haven’t gained or lost anything regarding the absolute performance at the end of the period, but we gained a “less emotional pain” during the whole investment period.
This also means that we obtained a better risk-adjusted performance: indeed the Sharpe Ratio of this “hedged” portfolio is 0.75, while the Sharpe Ratio of the “non-hedged” portfolio is 0.62.
Did we find the Holy Grail of Investing? Absolutely not.
In fact, during a bull cycle or even during a period without important stock market drawdowns, if we added the VXX in our portfolio we would lose both in terms of absolute performance and in terms of risk-adjusted performance, compared to the same portfolio without the VXX.
But we have to bear in mind that long periods without a crash are not the rule: in fact, market and market crash are an indissoluble pair.
By adding a hedging investment vehicle in a certain way in our portfolio, we might increase our chances of survival in financial markets without removing from the portfolio the “positive CAGR component” related to the long-term bullish trajectory of the markets, and we surely decrease the emotional pain we have to bear in the future when things won’t be as good as we hoped.
Disclaimer: This newsletter is for informational and entertainment purposes, and should not be construed as personal investment advice.
Users of this Newsletter are responsible for their own investment decisions.