During times when the CBOE Volatility Index® (VIX®) is at relatively low levels, we often receive investor questions such as – how much of an allocation might I make to VIX futures and options in order to try to diversify my portfolio?
RELATIVELY LOW RECENT VALUES FOR VIX
In 2012 the average daily closing value of the VIX was 17.8, its lowest such value since 2007.
Due to fiscal cliff concerns, the VIX Index spot price rose to a close of 22.72 on Dec. 28th. However, both the VIX spot index and the VIX Jan. 2013 futures closed below 16 on all of the trading days so far this calendar year (through Jan. 14th).
PAPER BY UNIVERSITY OF MASSACHUSETTS
In trying to answer the question re: allocation to VIX, one could explore the 2009 paper by the University of Massachusetts “VIX Futures and Options — A Case Study of Portfolio Diversification During the 2008 Financial Crisis,” which analyzes data from March 2006 to December 2008. The paper first examines investment performance for different investment portfolios during the second half of 2008, when the increased correlations among diverse asset classes generated significant losses for many investors who previously considered themselves well diversified. The study then explores the impact of adding various exposures of long CBOE VIX futures or long CBOE VIX call options to those portfolios.
For a traditional portfolio of stocks, bonds and alternatives during the five-month time period from August through December 2008, the following are three ways in which long volatility exposure was added, and the results are presented for the 5-month period studied:
(1) Using a 10% allocation to long near-term CBOE VIX futures–
– Total returns were improved by 15.7 percentage points (improvement to -4.0% from -19.7%)
– Standard deviation was reduced by about one-third (to 16.3% from 25.3%)
(2) Using a 3% allocation to long at-the-money one-month CBOE VIX calls, total returns were increased to +20.8% from -19.7%
(3) Using a 3% allocation to long 25%-out-the-money one-month CBOE VIX calls, period returns increased to +97.2% from -19.7%
The paper concludes by noting that “…investable VIX products could have been used to provide some much-needed diversification during the 2008 financial crisis.” A link to the paper is available at www.cboe.com/vix. Two of the figures from the two-page summary of the paper are below.