Investing in volatility

Natasha Jhunjhunwala, of Barclays Capital, explains the benefits of investing in equity market volatility

Following sharp correc­tions in the equity ­markets over the past few years, investors are increasingly looking for ways to mitigate their investment portfolios against market crashes.

Some have moved their money into capital protected structures that promise to return 100% of the capital invested (subject to the credit risk of the issuer), if the holder can wait until the maturity of the product. However, others are looking at more dynamic solutions by diversifying their investment into assets with a low or negative correlation to equity markets.

Portfolio diversification is not a new concept, and equity investors have historically turned to a variety of alternative investments in search of de-­correlated returns. However, as witnessed during the credit crunch, this has not always yielded the returns they had hoped for, and during the global meltdown of 2008, correlations tended towards 100%, as all asset classes suffered losses.

Lessons from the crisis sent investors once again in search of assets to give them greater diversification of returns. One of the assets that has grown popular as a result is equity market volatility. The evolution of the volatility market has meant that individual investors are now able to access what was once a tool used only by hedge funds and other professional investors.

Realised and implied volatility

Equity volatility measures the magnitude of price movements for a given asset and is usually regarded as a measure of the riskiness of the asset. This can be calculated on a historical basis looking at the price movements for the asset each day over some period in the past. This is known as ‘realised volatility’. Volatility can also be measured on a forward-looking basis, which is the market expectation of volatility for the asset in future, known as ‘implied volatility’.

The most commonly used indicator of implied volatility in equity markets is the VIX index, often referred to as a ‘fear gauge’ for US equity markets. It measures the expectations of risk in the equity market and can be seen to spike during periods of market distress. Similarly in Europe, the VSTOXX index is a measure of risk in the European equity market.

As measures of expected risk, these indices effectively ­represent market sentiment. They can therefore react very quickly to new information. This can be seen clearly during the period of the Lehman Brothers bankruptcy, when the VIX index rose steadily and remained elevated for the remainder of the year as market uncertainty prevailed. During this period, equity markets continued their decline and equity portfolios fell in value.

Including an allocation to volatility during times such as these could improve the overall performance of the portfolio, as the volatility investment could yield positive returns in such market circumstances.

How to buy volatility

While they are used widely as indicators of risk and fear in the market, the VIX and VSTOXX are not directly investable. For many years, investors have sought ways to gain exposure to implied volatility. However, this was traditionally only available to professional investors through complex over-the-counter derivatives.

In the mid-2000s, listed futures contracts were introduced for the VIX and VSTOXX indices. Futures are instruments that give their holder the obligation to buy the underlying asset at a predefined price at a fixed date in the future. In this case, an investor buying the future on VIX or VSTOXX would receive the difference between the prevailing market price of the index and the predefined price at which they entered the futures contract. The introduction of such futures gave investors a way to buy and sell the volatility indices on a forward basis. However, the use of these contracts was still restricted to market professionals with access to the futures market.

The VIX views

In January 2009, it became possible for investors to buy two exchange-traded notes linked to the VIX. These notes give investors the ability to gain exposure to the VIX index, through a simple and transparent format that can be traded by anyone through their broker. The first note, called the VXX, gives investors exposure to VIX futures for a short-term maturity and is an effective product for investors wishing to take short-term views on volatility.

The second product, called the VXZ, is available to investors wishing to enter buy-and-hold positions where they enter a position with the view of holding it within their investment portfolio for a longer period of time. The VXZ gives investors exposure to VIX futures with a longer maturity.

While initially aimed at individual investors, these instruments have become widely accepted tools for trading volatility and are used by a broad range of investors including hedge funds, institutional investors and individual investors. As exchange-traded instruments, there are a number of market participants involved in the buying and selling of these notes, making them highly liquid securities with low- trading and execution costs.

The European market for notes linked to volatility indexes has developed substantially and investors now have access to the volatility of the European equity market through a number of products. One such is the VSXX, identical in methodology to VXX, which gives investors access to VSTOXX, the European equivalent of VIX. While the European and US markets are often correlated, in recent months, concerns about European sovereign credit risks have led to a significant over performance of European equity volatility relative to US equity volatility.

Diversification benefits

Investors have historically used a variety of alternative assets classes to diversify their equity portfolios. However, they discovered that these instruments are not always efficient diversification tools during a global market crisis where all markets fall in unison.

Investing in volatility as an alternative asset class has proven to provide diversification benefits, because of its negative correlation to equity markets, particularly in periods of extreme market distress. The early success of exchange- traded products in this market indicates that there was pent-up demand for a liquid and transparent method of accessing volatility.

Using these products, individuals are able to trade volatility, as easily as stocks, through their regular brokerage channels. With an outlook of continued uncertainty, a growing number of investors are likely to enter the market for trading volatility through these products.