We recently have received the following questions:
(1) has the CBOE Volatility Index® (VIX®) recently been at relatively low levels? and
(2) if so, how much of an allocation might I make to VIX futures and options in order to diversify my portfolio?
In 2012 the average daily closing value of the VIX was 17.8, its lowest such value since 2007 (see Chart 1 below). 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) (see Chart 2 below for the last month’s prices that fluctuated in regard to the fiscal cliff outlook).
PAPER BY UNIVERSITY OF MASSACHUSETTS
In trying to answer the question re: allocation to VIX-based products, it is not possible to provide a perfect answer that could predict all future price movements. To gain a general sense of allocations that could be considered, 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 —
“ … while a passive long volatility exposure may result in negative returns in the long term, it may provide significant protection in downturns. In particular, 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. Before investing in VIX-based products, please read the applicable risk disclosures and information on contango, basis risk, and roll costs. Two of the figures from the two-page summary of the paper are in Charts 3 and 4 below.