At the CBOE's 2nd annual Risk Management Conference held in Hong Kong last month, volatility experts Tanuj Dutt and Selim Piot presented the potential diversification benefits of the inclusion of short volatility strategies in traditional portfolios.¹ Specifically, Piot highlighted the benefits of replacing part of a portfolio's equity risk with short volatility risk, including short positions in VIX products.

As an asset class, volatility is still far from universally accepted, but Dutt and Piots' observation that it may offer diversification benefits is not new. In April 2013, Tony Cooper, a data scientist from New Zealand, published a somewhat obscure academic paper in Elsevier's Social Science Research Network entitled 'Easy Volatility Investing'.² In that paper Cooper laid out some of his early thinking behind volatility investing, including developing the concept of Volatility Risk Premium (VRP). Under the heading of 'The Lure and Intrigue of Volatility,' Cooper highlighted the exceptional returns from short volatility strategies and explained why these returns come about.

In essence, Cooper's argument, and ultimately that of Dutt and Piot as well, is that while returns from short volatility strategies are very volatile, their correlation with traditional assets is such that including them in 60/40 stocks/bonds portfolios may improve overall risk-return. Cooper recommends inserting a 10% allocation to short volatility and argues that a mix of 55:35:10 'boosts portfolio performance, reduces its risks, and diminishes possible drawdowns from the volatility component.'³

But Cooper goes beyond arguing for a static allocation to short volatility and presents a series of more complex dynamic strategies to try to optimize the short volatility allocation to mitigate drawdowns. Cooper's strategies vary in complexity, but include methods for varying a portfolio's volatility exposure with changes in historic S&P 500 volatility and/or the shape of the VIX futures curve. He concludes that over the period of his research - between October 2011 and April 2013 - the best of these tactical strategies would have yielded a massive 399%!

The challenge with short volatility strategies, however, is that they do carry considerable risks. The biggest risk by far is the severity and speed of potential drawdowns. Volatility tends to rise much more quickly than it falls, meaning that a short position is likely to lose value much more rapidly than it is able to add value. For example, the largest spike in the VIX index over the last five years was when VIX reached 40.74 on August 24, 2015 following news of a slowdown in Asia. The index jumped to that level from 13.02 in just one week. However, it would be over six weeks before the index would close below 20 and thirty weeks before it would trade with a 13 handle again.

Investors often try to solve the drawdown problem by pursuing tactical short volatility strategies using a market timing element. For this type of investment strategy, investors rely on market indicators, or "signals," to determine the optimal points at which to exit a short volatility position. We believe investors should be cautious here. Strategies governed by trailing indicators may be unsuccessful at forecasting sudden spikes in volatility and could potentially offer investors a false sense of security.

Investors may also look to manage short volatility positions using continuous active management. In this type of investment strategy, a trader must continuously monitor market events' impact on their short volatility position. Volatility moves happen intraday and many times overnight (from a US perspective) so by "continuously" we basically mean 24-7. Most traders are not able to dedicate this kind of time to their positions and therefore may be ill-advised to take this approach. Given the speed with which volatility spikes can occur, half-measures here may avail nothing!

Finally, investors may consider a long-term, purely passive approach to volatility investing. In this type of investment strategy, investors must come to accept the drawdown risks that can arise from short volatility positions. They must consider whether they are willing to "double down" on potentially massive drawdowns or just weather the losses. Although this approach exposes the investor to all potential drawdowns that may come to pass without the potential benefit of tactically avoiding them, it may provide some peace of mind. How so? If an investor sizes the position appropriately and decides in advance how she will respond to market moves, this can go a long way to helping her sleep at night.

Footnotes

1. Short Volatility Strategies Discussed at CBOE RMC

2. Cooper, T. (2013). Easy Volatility Investing, SSRN 2255327.

3. Ibid. pg 28