November 2010

VOLATILITY TRADING: investing in fear

volcano-craterInvestable volatility products are gaining in popularity. But critics point to issues of complexity, definition and transparency, reports Fiona Rintoul Volatility is essentially a measure of fear in the market. “High volatility equals high uncertainty,” says Konrad Sippel, executive director and head of sell side at Stoxx, an index provider. In other words, when equity market volatility is up – as it has been so often of late – equities themselves are down. The question is: how to make use of this phenomenon in a portfolio? It’s a question that has become increasingly easy to answer as the range of investable volatility products has experienced exponential growth over the past two years.

The potential advantages of investing in volatility are easy to understand. “Volatility has a strong negative correlation with equities and so it adds value as a portfolio diversifier,” says Antti Suhonen, head of origination, equity and funds structured markets at Barclays Capital.

And that negative correlation of equity volatility doesn’t just apply to the equity markets, according to Suhonen. “You can find similar patters in the credit market. Spikes in the credit spreads often coincide with rising equity volatility.”

As well as being a portfolio diversifier, volatility can protect against certain risks. Joe Kohanik, vice president of fixed income and derivatives products at Linedata, gives the example of an investor who holds a stock that could be affected either very positively or very negatively by a forthcoming announcement.

“The investor can keep hold of the stock and hedge the risk with volatility,” he says.

So far, so straightforward. However, there are voices of caution in the market. Investable volatility products can be complex. Witness Stoxx’s catchy description of what its new Euro Stoxx 50 Volatility Short-Term Futures Index (VStoxx) does: “The new index measures the performance of a hypothetical, rolling portfolio invested into constant maturity implied volatilities on the underlying Euro Stoxx 50 Index.”

Excited? Well, that’s just the start. The new exchange-traded notes (ETNs) which have been launched on this index, as well as the two ETNs (one short-term and one mid-term) launched on the Chicago Board of Options Exchange (CBOE) Volatility index, the Vix, don’t invest directly in the indices they reference because that’s not possible. Instead they invest in futures contracts on those indices.

“The Euro Stoxx 50 Volatility Short-Term Futures Total Return Index is based on the performance of VStoxx futures contracts, which could involve roll costs and exhibit different risk-and-return characteristics,” explains the website of iPath, the brand name for ETNs from Barclays Capital, highlighting a couple of the risks associated with this type of arrangement along the way.

These impenetrable descriptions are the more problematic because ETNs are, of course, available to less sophisticated investors, possibly even to retail investors. There are other potential problems too. In all the excitement, it’s perhaps easy to forget that implied volatility is not the same as volatility and may behave differently. Then there’s the ‘normal times’ cost of hedging a portfolio against extreme events using investable volatility to think about. Interesting...
Nonetheless, it is fair to say that investable volatility is appearing more and more on investors’ radar at the moment. There are two main reasons for this. The first is that markets have become a lot more volatile over the past couple of years. This doesn’t just mean that people are more scared, therefore more likely to look for ways to hedge their portfolios against risk; it also means that trading volatility is more interesting.

“One of the things that happened during the crisis was that assets that are typically stable, for example bonds, became more volatile,” explains Kohanik. “That has made things more interesting from a trading perspective. If you’re a trader you want to trade 20% volatility because the opportunities to make money are greater.”

At the same time, volatility products have evolved significantly over the past two decades, the present culmination of this process being the recently launched Vix and VStoxx ETNs. This has made investable volatility more accessible to a wider range of investors.

“Investing in volatility is attracting new types of investors from traditional long-only mutual fund managers looking at volatility as a diversification tool in their portfolios, to funds of hedge funds,” says Suhonen. “The creation of volatility ETNs has enabled even retail investors to access volatility.”

It is perhaps worth remembering at this point that, like contraception, investing in volatility is not new. People have found ways to do it right from the start, even if those ways weren’t always as efficient as the ones we have today.

“There have been ways to access volatility since the beginning of the markets,” says Kohanik. “One very common one is the options market.”

The problem with accessing volatility that way was that investors didn’t just get volatility exposure, says Suhonen; they also got other exposures, which would need to be dynamically hedged, and the volatility exposure didn’t stay constant over time.

Thus, during the 1990s people began to look for other ways to access pure volatility. Variance swaps were launched, and later, in the 2000s, futures and options on the CBOE index were introduced.

Launched in 1993, the Vix index measures expectations of near-term volatility conveyed by the S&P 500 index option prices. The Vix futures and options that became available after the Vix index was recombobulated in 2004 provided a new way for investors to access volatility. But there were still problems with access and transparency.

“Variance swaps were only accessible to the banking community, larger institutions and hedge funds,” says Suhonen. “And they lack transparency. They are traded over the counter, so by definition there is limited transparency of pricing and investors have to consider counterparty risk.”

Later, exchange-traded futures contracts were introduced. These solved the transparency problem, but not the access problem. “Not everyone is capable of trading futures or wants to trade them,” notes Sippel. The most recent development is the ETNs on the Vix and VStoxx indices.

“Both concepts have one goal: to give an easier way of investing in volatility,” says Sippel, adding that ETNs are not the answer for everyone, but do open volatility investing up to a wider range of investors.

“The best way [to invest in volatility] depends on who you are,” he says. “If you’re happy trading futures you can do that. If you’re not sophisticated or don’t want to hold futures positions, ETNs are a good solution.”

The VStoxx index, which is in fact a family of indices that includes 12 rolling sub-indices, and the VStoxx ETN, launched in April 2010, represent what may be the beginning of a wider geographic segmentation of volatility. The potential utility of this was underlined by the timing of the European ETN’s launch, says Suhonen. Shortly afterwards there was the 6 May flash crash followed by the European sovereign credit turmoil.

“That created a couple of interesting scenarios,” he says. “There was a lot of market volatility at that time and therefore a lot of interest in volatility. By giving investors access to European as opposed to US volatility we were able to provide a better and closer hedge against the idiosyncratic risks which apply to Europe.”

In the meantime, Stoxx had made a further addition to the VStoxx index family with the launch of the Euro Stoxx 50 Investable Volatility Index. The index has been licensed to BofA Merrill Lynch to offer exchange-traded products and over-the-counter derivatives linked to the index, further expanding the range of European volatility products available to investors.

A next step might be to look at Asia. Korea could be interesting, and China and India are of interest, notes Sippel. “We are following the development of futures markets with quite big volumes in Asia,” he says. “We’ll look at these markets and see how the derivatives markets develop.”

However, before any new developments in other geographic areas take place there is likely to be a wave of more elaborated strategies taking in further parts of the curve. Next up is a VStoxx mid-term futures ETN from Barclays Capital due to be launched shortly.

As Kohanik points out, the investment banking world is already offering a wide range of volatility strategies through structured notes. In the future, he suggests, where there is volatility we will see ETFs and ETNs popping up.

That will bring a wider range of volatility strategies to a broader audience – perhaps even to pension funds. They have been slow to the party but have definitely shown interest.

That, of course, will mean a brighter light being shone on these products. Then perhaps we will find out whether the naysayers, mainly amongst the savvy investing American public, who will clog your screen should you enter the term ‘Vix ETF’ into Google, are right to be afraid of these tools for investing in fear.

©2010 funds europe

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