Limiting drawdowns by adding volatility exposure to your portfolio

Portfolio with long position in Volatility
A traditional investment strategy is to use the 60/40 portfolio, where 60% of your portfolio is invested in equities and 40% in government bonds. Historically the 40% in fixed income acted as a stabilizer as governmental bonds tend to have relatively lower volatility and rise in times of market stress, and they tend to increase in value when equities have negative returns. However, in certain scenarios with high market uncertainty, both of these positions may have negative returns, so one way to hedge is to include a small exposure to the VIX index. Therefore investors should consider reducing their fixed income position and invest this reduced fraction in a long volatility position.  In the next paragraph, we describe two portfolios. Portfolio 1 has an allocation of 60% to equities and 40% to government bonds by going long the MSCI World Index (EUR Hedged) and European 7-10 year Government Bonds respectively.  Portfolio 2, has the same 60% equity allocation but reduced its bond holding by 4% and allocated this fraction into a long VOOL position. There is no strong reason to allocate precisely 4% of the portfolio to volatility, investors can use other fractions instead. All instruments used in these portfolios are tradable for retail-clients.

Historical performance portfolio with VOOL
In the last 8 years, portfolio 1 realized higher annualized returns than portfolio 2 except for 2015 (roughly the same return), 2018 and 2020.

In 2015, we saw a global stock selloff due to a slowdown in the Chinese economy, the Greek debt default crisis and rising yields in the US (FED turned Hawkish). In 2018, stock markets performed poorly due to uncertainty around Brexit and the trade war between the US and China. In 2020, markets have been volatile due to the COVID crisis and the US Election.

The premium paid for exposure to volatility can be seen as an insurance premium in case volatility changes. If volatility increases, mostly when markets go down, you’ll enjoy a negative correlation from the VOOL ETF. The table below shows that the portfolio with a long position in the VOOL has less extreme drawdowns than the 60/40 portfolio. Moreover, the Sharpe Ratios is also higher for the portfolio with long VOOL. This is a metric that compares the realized return relative to the volatility (standard deviation) of the portfolio.

Comparing the portfolio without and with the volatility instrument shows that a long position in volatility protects you from larger drawdowns, on the cost of a drag on the portfolio performance in calmer markets. Hence, investors could consider a small long position in volatility as a hedge in turmoiled markets. If you are afraid of upcoming events and want to protect against drawdown, consider a long VOOL position in that period.

However bear in mind that, even with this volatility allocation, there is still a risk of losing money. Hence, make sure you understand the VOOL ETF before investing in it. Find more information in the appendix below or in the product specification.

Appendix

What is the VIX?
The VIX-index measures the implied volatility for options with the S&P 500 index as underlying. The VIX is often referred to as the Fear Index, as a higher value indicates higher levels of risk, fear or stress in the market. Before the COVID-crisis in March the VIX was around 15, which indicates the expected annualized change in the S&P 500 index. From a monthly perspective, this indicates that the S&P 500 index could increase or decrease by 1.25%(=15%/12) in the next 30-day period. Hence, a VIX around 15 indicates a relatively low volatility environment. To put this number in perspective, the highest VIX close was 82.69 on the 16th of March 2020. The highest intraday value that the VIX ever reached was 89.53 during the financial crisis in 2008. 

What is the VOOL ETF?
The VOOL ETF tracks the VIX Futures via a methodology called Enhanced Roll. This sounds complicated but for those with an eye for detail it essentially means switching between a portfolio with short-term VIX futures and a portfolio with mid-term VIX futures to ensure a cost-efficient exposure to the volatility in the overall equity market. The short-term VIX futures track returns of a portfolio consisting of monthly VIX futures contracts and rolls the first-month contracts into second-month contracts on a daily basis, while maintaining a weighted average of one month to expiration. The mid-term VIX futures portfolio is similar except that it tracks the return of positions in the 4th, 5th, 6th and 7th month contracts.

How to replicate this in SaxoTraderGO?

Portfolio 1 is a conventional 60/40 portfolio and exists out of 1) Equity ETF: iShares MSCI World Eur Hedge UCITS (Ticker: IBCH:xetr) and 2) Bonds ETF: Xtrackers II Eurozone Government Bond 7-10 UCITS (Ticker: X710:xmil), which gives you exposure to government bonds denominated in Euro with a remaining time to maturity of 7-10 years. 

Portfolio 2 has the same 60% equity exposure, but reduces the exposure to bonds to 36%. The reduction of 4% is entirely invested in the volatility ETF: Lyxor S&P 500 VIX Futures (Ticker: VOOL:xetr). This ETF tracks the benchmark index S&P 500 VIX Futures Enhanced Roll.