Hedging with Long Volatility Positions

When it comes about protecting the portfolio during downturns, I often I read about diversification either using a combination of uncorrelated asset classes or through equities ETFs that cover different regions of the World.

Does it really work?
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When sell-offs start and the fear gauge (VIX, the volatility index) spikes, all of a sudden loosely correlated equities ETFs become correlated; see Figure 1. This means that if the broad market goes down and the correlation is nearly 100% then all the rest goes down. Diversifying through equities ETFs that cover different regions of the World is not really helping when we need it the most. The same is true when diversification is done across different sectors.

Figure 1: 1 month rolling correlation between the S&P500 and three others equities ETFs.

How about diversifying using different asset classes?

If we thing about investing in gold, medium term bonds (e.g. IEF) and equities (e.g. SPY) and allocate capital based on the risk parity methodology, definitely the maximum drawdown is reduced during downturns. For instance when in 2020 Q1, the S&P500 went down by nearly 35%, this allocation would have experienced a maximum drawdown lower than 7%. Unfortunately everything has a cost and this strategy has the drawback of very low annualized return: 3.36% vs. the 15.52% of the S&P500 (2009-2021).  

What to do about this? Can we break the trade-off between annualized return and the maximum drawdown?
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VXX, the VIX short term future ETN, might do the trick and help out our portfolio. By the way it was designed, VXX decays over time. Buying and Holding this ETN is a financial suicide; see Figure 2. The good news is that when the market crashes, this ETN spikes in value. For instance between February and March 2020, in the panic of the pandemic, VXX increased by 436% while the S&P500 dropped by 35%. 

Figure 2: Buying and holding VXX.

How to take advantage of these spikes?

The first thing to do is to understand when to enter a long position in VXX. To do that we must look at the VIX term structure. This chart can be found on vixcentral.com and is shown in Figure 3. Each dot represents a VIX future value while the dashed line represents the VIX spot price. If all the future contracts values are pointing upwards and the spot VIX is below the futures then no major sell-off can be expected. Troubles can be expected when the first front two months are ca. 10% below the VIX spot value. If this happens, it is highly probable that a major sell-off is underway and it will continue even stronger in the next few days. When this happens then the VXX ETN spikes quite rapidly.  For the sake of brevity, lot of information on how to read the VIX term structure have been omitted. 

Figure 3: The VIX term structure on March the 29th 2021.

By knowing that the VXX spikes when the first two front months are ca. 10% below the VIX spot price, assuming our portfolio is made 100% of equities, then we can think of taking part of it and allocating it to a long volatility position.

Table 1 shows the CAGR and maximum drawdown as function of the percentage of the portfolio allocated to a long volatility position. It is assumed that the investor sells all the equities positions as soon as the first two front futures are 10% below the spot price. In this example, it is  assumed that the equities are represented by the S&P500.
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Table 1: annualized return of investment and maximum drawdown as function of the portfolio allocation to a long volatility trade.

​By allocating 30% of the portfolio to a long volatility trade is effective in maximizing the annualized return while minimizing the drawdown. In the same period, buying and holding the S&P500 would have resulted in an annualized return of 15.3% and a maximum drawdown of 34%. The backtest of this optimal case is shown in Figure 4.

Figure 4: Equities portfolio hedged with a long VXX position versus buying and holding equities.

In conclusion, diversification is not protecting our portfolio when we need it the most. Equities become all correlated when the market goes down. Diversifying using different asset classes can reduce the drawdown but the long term return is penalized. By wisely opening long volatility positions when the equity market sinks can provide an effective hedge to reduce the maximum drawdown while improving the annualized returns.