In the second part of our coverage of the volatility panel at SRP's Annual European Structured Products & Derivatives Conference in London the panellist discussed a new generation of volatility products, the challenges of contango, regional differences and whether retail investors should be able to buy volatility or not.
"The Vix spot index came out in 1993 but is not really investible," said Matthew Moran, vice president, business development, Chicago Board Options Exchange (CBOE). "If you want investible type products you have got to look what is trading out there. You have got the Vix futures, which was introduced in 2004, Vix options in 2006 and the Vix exchange traded products (ETPs) started to be introduced in 2009."
"We have seen a new generation of products, the S&P 500 Vix (VXX) for example, products with different hedging techniques," said Colin Bennett (pictured), author of Trading volatility, correlation, term structure and skew. The VXX is arguably the best known ETP, according to Moran. "The VXX came out in January 2009 and one of the challenges faced by the market was the fact that some of these first generation products have been dealing a lot with contango," said Moran. "Some might jump to the conclusion that all volatility indices are going straight down but there are third generation indices now, benchmark indices and also ETPs, that are more dynamic, and do try to mitigate contango, and some have certainly had a good performance since 2009."
According to Bennett the VXX, at one stage, had more volatility underlying than the entire Vix futures market although it differs per region. "You have different types of flow across the globe," said Daniel Danon, volatility portfolio manager at asset manager Assenagon. "There are all these structured notes in Asia that push the volatility curve in a certain direction, you have the variable annuities in the US that push the longer end of the curve and in Europe there is a mixture, and all this - globally - opens a lot of popular trades. These are the dynamics."
At Assenagon, we go one level below and not only focus on the index but also focus on single stocks because these are less crowded underlyings, said Danon. "We try to finance long volatility exposure on single names, where usually the volatility is higher than on index, by finding the best hedge," said Danon. To be able to do this, the asset manager sells liquidity benchmark where the volatility can be overpriced, according to Danon. "The flow can go to overpay a little bit the volatility of for example variable annuities, a bit like hedging flow on the S&P that pushes volatility to a premium which is justified but from a quantitate perspective is overdone," said Danon.
"I think market liquidity has dried up a bit, compared to what we have seen last year and people are anticipating higher volatility overall," said Pranjal Trivedi, head of bespoke indices at Investec. "The world has moved on. There are concerns about Brexit, China, Syria, the low oil price, there is a rise of anti-austerity politics in Europe." High volatility is here but it offers the opportunity to deliver different type of products, according to Trivedi. "January hasn't been the best month for people investing in global strategies, global stock selection and factor investing," said Trivedi.
According to Trivedi, people are looking more at upside participation and capital protection. "We will definitely see a demand for strategies, bespoke indices which can provide this participation and then high vol, basically call-overwriting strategies, will make a comeback possibly by the end of this year," said Trivedi.
"We have been doing this for several years, so have seen a few different cycles and the liquidity is definitely becoming really challenging on single stock at least," said Danon. The main providers on volatility, if you want to buy in a decent size are the structured products desks, according to Danon. "They get inventory so they are the first to decide on the flows so they can provide a nice supply of volatility."
In the US, if you look at options-based mutual funds, there has been a study which suggests that in the year 2000 there where 10 of these funds and that has grown to 119 last year, said Moran. "We get more traditional fund managers coming into this market saying we believe we can go out there and sell these overpriced options," he said. "That's a key point too, overpriced options. An important thing to look at is if you are consistently selling options where do you see this overpricing. You generally see it in the index options."
The panel was divided on whether retail investors should be able to buy volatility, but agreed that education would be pivotal. "There are many different Vix ETPs and also futures and options which are available to retail investors," said Moran. "Morgan Stanley said they will not put the short-term Vix on the approved list of contango, but if the brokers take a 30 minute education session to learn how to fit this in a portfolio, what are the risks?" he said. "Brokers will be mandated. Education is very key here. Should you ban all things that might go down?" Around 2008 the drawdowns (the peak-to-trough decline during a specific record period of an investment, fund or commodity, usually quoted as the percentage between the peak and the trough) for developed markets stocks were down 50%, emerging markets stocks were down 60%, and commodities were down 50%, according to Moran. "Did anything go up? Well treasury bonds went up about 20% but the Vix went up by 300%. So does it make sense to ban that from the portfolio entirely? I would suggest that with proper education it certainly can make sense to save a small part of that in your portfolio."
Volatility for retail investors would require a lot of education, according to Trivedi. "I think using these products in structured products is going to be a step too far at this moment in time," he said.
There are some new papers which have come out this month which suggest that there is a volatility risk premium in implied vol for index options, selling index options consistently, said Moran. "The volatility risk premium is about two volatility points which is huge. That, combined with equity risk premium, you have potential for outstanding risk adjusted returns - not just for past performances but also for future performances - including short vol in your portfolio buy-write strategy and put-write strategy," he said. "If you are looking for strong risk-adjusted returns this is certainly something that needs to be explored."
If you talk about pure vol premium, and we have been entering a strategy were you actually short variance, to catch the real premium on the curve, I think right now you would still be recovering the losses of 2008, said Danon. "Choosing a call-overwriting or put-overwriting strategy can make sense but capturing this with vol premium is a strategy that we would not actually engage in."
According to Moran, CBOE has buy-write and put-write indices. "In general, if you look at 29 years, the general principal, if the stock market is up less than 5%, buy-write and put write have outperformed every single year. Including 2008 when the S&P was down 37%, buy-write and put-write were down too but not by that much," he said. "However if the stock market is up 20 to 30% then often the buy-write and put-write, because they are trying to get an upside, are not keeping up. So there is little bit of a trade-off there. You are not going for home runs, you are going for single, more consistent types of returns," said Moran.
There is correlation between the equity market and volatility, according to Bennett. "If you have a volatility selling strategy then you go long on the equity market. If you have positive equity risk premium you gain additional returns from the long equity market and you gain additional returns from shortened volatility," Bennett said. "You can find that while on single stocks the implied vol premium is probably what you expect, on the index side, because you have structured product flow, the fact that you have implied correlation which is far richer than normally, you can gain additional profit in addition to volatility risk premium." It is not exactly a controversial point that you should make more money shorten index vol than single stocks vol, said Bennett. "Typically with structured products you like to buy what is cheap and sell what's expensive."
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