A curious thing happened during Monday’s session, day two of the Brexit aftermath. As equities fell so too did the CBOE S&P 500 Volatility Index known as VIX. Many participants of course view the VIX as a way to hedge declines in equity prices through the many exchange traded products (sort of) tracking VIX and the options market.

The logic is simple, fear/uncertainty increases as stocks go down so the VIX rises and the products tracking it then hopefully capture some of that reaction. I’ve always been skeptical of this because it is possible that stocks go down and the VIX also go down which is what happened on Monday as shown in this chart from Yahoo Finance.

(Click on image to enlarge)

The equities/VIX relationship is not direct cause and effect it’s more of a rule of thumb along the lines of equities/gold. Gold tends to go the other way from equities but it doesn’t have to.

That the VIX can go the same way as equities occasionally, doesn’t necessarily mean using VIX is a bad idea but it may not be as efficient as some users would hope. The contrasts with funds that sell short one way or another. Here, direct cause and effect is in play.

Where VIX-related products are alternatives or diversifiers it is important to understand that all alternatives have drawbacks. I am not a fan of using the VIX products not only because the VIX doesn’t have to go up when equities decline but also because the funds don’t necessarily look like the VIX index for a myriad of factors related to what the funds are precisely meant to follow (a topic for another blog post).

Drawbacks are inevitable but part of due diligence is understanding what the drawbacks are to any alternatives you use if you use any, that is. Gold doesn’t have to have a negative correlation to equities but often does and it tends to have smaller daily moves than the VIX which I in my opinion makes it easier to own. Managed futures has a tendency to do very poorly in up markets, merger arbitrage relies on access to capital being possible, some expressions of market neutral and absolute return can get caught wrong footed at big turns in the market, hedge fund replicators will probably replicate hedge funds just fine but there is no guarantee that hedge funds will always do what investors want and so on.

All of the above is a reason to allocate to alternatives in small slices using several different strategies (for people who believe in them at all). It’s a much smaller problem if something like merger arb gets hit hard in some sort of one off event when it has a 3% weighting as opposed to a 10% weighting.