By Phil Strother, Head of Systematic Research, Fulcrum Asset Management
The attractive, insurance-like dynamics of volatility risk premia (VRP) strategies are relatively well known: positive returns are generally earned during stable and falling volatility regimes, but a proportion of these gains can be given back on unexpected volatility spikes, especially when they arise from low levels. In well-structured strategies, these gains then tend to be recouped relatively quickly, allowing returns to continue to compound.
We have witnessed a series of events this year that have proven to be a valuable live test of VRP strategies.
They have helped to show not only its long-term resilience, but the ability of diversified and well-structured VRP extraction strategies to generate long term positive returns.
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2018 follows two distinct, recent phases: 2014-2016 where the premium was flat to negative across a range of asset classes, and a resumption in 2017 of the strength of the multi-asset VRP to historically more normal levels.
Periods of low to negative volatility premium across assets are relatively rare in the context of longer term history. Why the VRP was suppressed is a topic of much debate, but one which is hard to definitively quantify. Some observers speculate that the volatility risk premium strategy had simply become overcrowded after a period of strong performance, thereby crimping future returns. We see this as an unlikely explanation since short volatility strategies in equities – which have seen the greatest investor interest by a wide margin – have fared no worse than more niche areas across other asset classes.
A more probable explanation of the general weakness of the VRP from 2014-2016 is the impact on option markets of global Quantitative Easing programmes, which likely supported asset values and reduced the perceived need for explicit insurance strategies. In turn, we believe this sufficiently suppressed the VRP such that the cost of extraction began to rival the available premium.
2017 demonstrated a return to some level of normality in the VRP across asset classes, with the more recent unwinding of Central Bank balance sheets likely increasing again the demand for options insurance, acting as a tailwind for VRP strategies. Levels of premium in each asset class were broadly positive, but by no means extraordinary versus their long-term average.
Implied volatility on multiple assets spanning four asset classes was also trading near multi-year lows through 2017: for example, in equities, this lack of volatility could be observed in the VIX, which traded in a range of between 9% and 16%, with a median value of 11%. It demonstrates that the absolute level of implied volatility is not the sole driving factor for extracting positive returns from the volatility risk premium, contrary perhaps to common perception.
The magnitude of the volatility spike in February 2018 brought an end to the calm, exacerbated given it came from extremely subdued levels. Much has been written about that short, sharp equity market sell-off and the technical dynamics behind the exaggerated spike in the VIX index. The corresponding impact of the significant correction on a plain vanilla volatility strategy was large, but bloodletting phases are an integral part of market structure: not only do they perform the beneficial function of removing weak holders of the VRP, historically they have been followed by a period of strong performance for well-structured volatility risk premia strategies: not all VRP strategies are created equal.
The common assumption about VRP strategies is that they capture the risk premium on equity indices — often the S&P 500. Conversely, Fulcrum’s approach is to extend beyond just the S&P 500 to 18 assets across four asset classes, capturing a wide range of volatility risk premium returns streams that demonstrate relatively low correlation to one another over time.
Diversification is key, therefore, but so too is implementation. Fulcrum extracts the VRP through baskets of strangles in commodities, currencies, and fixed income, but through calls alone in equities. Historically, an increase in the number of option strikes has led to stronger risk-adjusted returns from the VRP. However, in equity strategies, our analysis demonstrates that in the S&P 500, for example, a position in a basket of delta hedged calls has delivered similar risk adjusted performance to a basket of strangles (since 1996).
Further, the trade-off in more aggressively pursuing potential upside through selling puts at “enhanced” levels of implied volatility is that profits can be given up more starkly during a sharp market correction. However, as the vega exposure from short equity call positions falls away in a market correction, it enables equity VRP strategies to better protect prior profits, whilst still benefiting from the improved VRP mechanics in subsequent months, and aiding long term compounding of returns: a key component of multi-asset VRP strategies is to accrue profits in stable and falling volatility regimes, protect in periods of short term volatility spikes, and then return to profit relatively quickly after such events.
As 2017 demonstrated, therefore, where the volatility premium exists, a well-structured and diversified volatility risk premium strategy should profit. 2018 has shown that similarly well-structured multi-asset volatility programmes can weather volatility shocks, recover quickly to continue compounding gains, and remain a source of returns that is largely independent of traditional equity and fixed income markets.
Whilst we cannot predict the future, the persistence of the volatility premium across asset classes and over time underpins the positive outlook for robust, diversified volatility risk premia strategies, irrespective of the bumps we will inevitably face along the way.