2022 has been all about volatility and how investors should manage it in their portfolios. With stocks and bonds both in and out of bear market territory, there’s a lot of focus on ways to hedge portfolio risk in an effective way. Stuart Barton, the Chief Investment Officer of Invest In Vol and Volatility Shares, and Jim Carroll, Portfolio Advisor and Manager at Toroso Advisors, join the Think Tank to discuss the state of volatility in the markets.
VIX products were viewed as easy money until 2018 when volatility spiked and some of the largest ETPs went bust. Since then, contango in the VIX markets hasn’t disappeared, but it is become less persistent. As “volmaggedon” gets further and further in the rearview mirror, interest in these products has drawn a lot of interest again and that could help stabilize contango going forward. Prior to 2018, investors thought they could make money almost daily by shorting volatility. They’ve since learned that this isn’t always the case.
Are investors approaching volatility investing differently today? Barton says that from his point of view, not a lot has changed, although the way they invest in it has. He feels that people’s trust in exchange-traded notes has changed, and they realize the structure has disadvantages. Since they are credit notes, the issuing bank could default or simply close out the notes at any time. Carroll notes that if you understood how they were constructed and operated, they did what they were set up to do for the most part. He does agree that there are some disadvantages and issuers are trying to address some of the structural issues.
Carroll says that it is impossible to forecast the future of volatility, but he uses a fairly simple number as a helpful guideline - the rolling 1-year VIX moving average. He feels that if it gets above 20, there is a tendency for the markets to experience disruption. He clarifies that the VIX and volatility is a condition, not a trigger or trade signal. He usually feels better about investing in the markets if the rolling VIX average gets below 20, but, again, that’s just a guideline.
How should investors approach using the VIX to maximize its value? Barton says that the argument for investing in volatility is the same as the argument for having life or homeowners insurance. Derivatives fulfill the need for insurance and protection. He explains that while market participants will say that VIX products aren’t buy-and-hold investments, they can be if you want to use them as protection and are aware of the risk/return profile. They are not instruments where you’d expect a consistent return or profit. It is insurance that can help protect you in a worst-case scenario.
There’s a lot of debate on whether or not the VIX is an effective indicator or if it’s constructed correctly. It is supposed to be implied volatility looking forward over the next 30 days, so there is some investor expectation built into it. The composition of the S&P 500 will also play a role. It can help mute some volatility, but the correlation of the index’s components also plays a factor. If it becomes top-heavy or dominated by one sector, such as tech over the past decade, it can potentially enhance the volatility profile.
Other key takeaways:
- Investors need to be aware of the structural issues of investing in VIX ETPs. ETNs can be closed or delisted with little warning. Products, such as VXX, are closed in terms of creations right now. These factors can impact how traded products are priced relative to the underlying VIX. There are logistical risks that need to be considered.
- There are virtually no other volatility markets that have liquid futures trading. You can try to synthesize something using different securities, but it’s not easy.
- Is there an opportunity for innovation in VIX products? Barton says that most investors aren’t interested in the math. They just want the products to work the way they expect it to. The VIX was designed to be an index, not an investment, so there may not be the same interest in innovating.
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