VIX and the Indexing of Volatility

Transcription

1 VIX and the Indexing of Volatility A Presentation for the CBOE RMC 2013 Frank Luo S&P Dow Jones Indices March 2013 McGraw-Hill

2 What is VIX? Opinions on VIX range from Benign: The VIX is Wall Street's version of the Seinfeld TV show: much ado about nothing. Barron s, January 12, 2013 To Bizarre: VIX index has inadvertently caused numerous catastrophic events to occur on the mainland United States.It is no surprise that in January 1993, the CBOE news conference in which Prof. Whaley introduced the VIX was followed by the February 1993 bombing of the World Trade Center. A paper submitted to S&P for the SPIVA award, January

3 Good Indexing Principles Applied to VIX Although the VIX index was launched in 1993, the current form was introduced in 2003, with good indexing principles that laid the foundation for current success: Liquidity: use the options on S&P 500, the most liquid contracts. Tradability: VIX can be replicated by a static portfolio of S&P 500 options. It provides the critical link to develop tradable products to hedge and arbitrage OTC volatility derivatives. Transparency: VIX is calculated directly from option prices in a model independent way as follows: 3

4 Evolution of Volatility Indices Implied Volatility Indices Volatility Futures Indices Intelligent Roll Volatility Futures Indices Volatilitymanaged indices : VIX 2003: VIX relaunched 2004: Futures on VIX 2008: S&P 500 VIX Short and Mid Term Futures Index 2009: VIX ETNs S&P 500 Dynamic VIX Futures S&P 500 VIX Futures Enhanced Roll S&P 500 VIX Futures Term Structure S&P 500 VEQTOR S&P Financial Sector VEQTOR S&P HY VEQTOR S&P HD VEQTOR CBOE Tail Risk Hedge Strategy CBOE Low Volatility Measuring Trading Investment 4

5 Trading of VIX Products So far, most VIX products are designed to be trading, their success is reflected in huge increase in trading volume: VIX Futures: In January 2013, VIX Futures had record average daily volume (ADV) of 137,988 contracts. At current price of 15, the average daily dollar volume is $2 Billion. VIX ETNs: VXX alone has 35mm 1-month ADV. At current price of 20, the average daily dollar volume is $700mm. Source: CBOE and Bloomberg 5

6 Next Frontier: Volatility As a New Asset Class 6

7 Two Timelines 1923: S&P introduced the index. 1957: Modern S&P 500 Index was created as an measurement of US stock market 1975: First S&P 500 index mutual fund by Vanguard 1982: Futures listed on CME on S&P 500 Index 1983: Options listed on CBOE 1993: ETF launched by SSgA on NYSE 1993: CBOE introduced VIX 2003: Current VIX was created. 2002: CBOE S&P 500 BuyWrite index introduced. 2004: Futures listed on CFE 2006: Options listed on VIX 2009: VIX ETNs Today there are over $1 Trillion directly invested in S&P 500. Average daily volume of S&P 500 Futures is over $100B. Next phase of growth of VIX products rests on the development of investment products 7

8 Volatility as an Asset Class Volatility has the characteristics for an independent asset class for asset managers: Investable A variety of volatility instruments available Diversification Benefits Negative correlations to risky assets (Equity, High Yield and EM bonds, Commodities) Risk on/risk Off Improvement of Risk-adjusted Returns Justified by Empirical analysis (Moran et al 2007, Luo et al 2011) Indexing Tactical Asset Allocations into Volatility References: Matt Moran and Srikant Dash, 2007, Journal of Trading; Frank Luo and Srikant Dash, 2011, S&P Dow Jones Indices. 8

9 S&P 500 Dynamic VEQTOR Dynamic Allocation between Equity (S&P 500), VIX (Short term) and Cash, with a stop loss at 2% over 5 days. Target Volatility Allocation Implied Volatility No Implied Volatility Implied Volatility Realized Volatility (RVt-1 ) Downtrend Trend Uptrend Less than 10% 2.50% 2.50% 10.00% 10% RVt-1 < 20% 2.50% 10.00% 15.00% 20% RVt-1 < 35% 10.00% 15.00% 25.00% 35% RVt-1 45% 15.00% 25.00% 40.00% More than 45% 25.00% 40.00% 40.00% Implied Volatility Trend is decided by the moving averages (MA) of VIX: if 5d MA is above 20d MA, +1 for uptrend signal; If 5d MA is below 20d MA, -1 for downtrend signal; The signal has to maintain for 10 consecutive trading days to count as a trend, otherwise it counts as no trend. Source: S&P Dow Jones Indices. Information provided for illustrative purpose only. 9

10 S&P 500 Financial Sector VEQTOR Index (Concept) Sector exposure may be volatile and cyclical. VEQTOR framework provides dynamic volatility hedge during market turmoil. Unlike traditional optimization and other stock-selection based volatility reduction mechanism, hedging sector exposure with VEQTOR framework is macro and not subject to the limitation of number of stocks in each sector. Correlation % % % % % % % Source: S&P Dow Jones Indices. Data is current through December 31, Charts are provided for illustrative purposes. Past performance is no guarantee of future results. This chart may reflect hypothetical historical performance. Please see the Performance Disclosure at the end of this document for more information regarding the inherent limitations associated with back-tested performance. 10

11 Performance History: S&P 500 Financial Sector VEQTOR Index Financial Select Sector Index Financial Select Sector VEQTOR Annual Return % 6.92% % -5.24% % 2.71% % 19.70% % 0.95% % 6.14% % 9.15% Annualized Volatility % 9.28% % 14.66% % 25.09% % 26.68% % 16.92% % 17.23% % 12.30% Source: S&P Dow Jones Indices. Data is current through December 31, Charts are provided for illustrative purposes. Past performance is no guarantee of future results. This chart may reflect hypothetical historical performance. Please see the Performance Disclosure at the end of this document for more information regarding the inherent limitations associated with back-tested performance. 11

12 Applying VEQTOR Framework to High Yield Bonds (Concept) High Yield Bond moves in tandem with the equity market. High yield bond prices shows negative correlation to equity volatility as shown on the right Barclays Capital High Yield Very Liquid Index S&P 500 VIX Short Term Futures Index Correlation % % % % % VEQTOR framework provides dynamic volatility hedge that works the best during market sell off. 0 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Source: S&P Dow Jones Indices and Barclay s. Data is current through December 31, Charts are provided for illustrative purposes. Past performance is no guarantee of future results. This chart may reflect hypothetical historical performance. Please see the Performance Disclosure at the end of this document for more information regarding the inherent limitations associated with back-tested performance. 12

13 Performance History for HY Bond VEQTOR Barclays Capital High Yield Very Liquid Index High Yield Bond VEQTOR Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Barclays Capital High Yield Very Liquid Index High Yield Bond VEQTOR Annual Return % 1.45% % 65.56% % 12.39% % 7.32% % 8.25% Annualized Volatility % 9.92% % 9.37% % 4.86% % 7.01% % 4.86% Source: S&P Dow Jones Indices and Barclay s. Data is current through December 31, Charts are provided for illustrative purposes. Past performance is no guarantee of future results. This chart may reflect hypothetical historical performance. Please see the Performance Disclosure at the end of this document for more information regarding the inherent limitations associated with back-tested performance. 13

14 S&P 500 Volatility-Hedged High Dividend Index (Concept) Tap into the Income Theme: Underlying High Yield Dividend index is built from 50 highest dividend stocks of S&P 500. Using dividend to pay for the VIX cost. Use VIX futures to hedge the downside risk Apply VEQTOR methodology to the HY dividend index VIX provides the downside protection when market sells off Source: S&P Dow Jones Indices. Data is current through June 30, Charts are provided for illustrative purposes. Past performance is no guarantee of future results. This chart may reflect hypothetical historical performance. Please see the Performance Disclosure at the end of this document for more information regarding the inherent limitations associated with backtested performance. 14

15 Performance Disclosure Some index concepts discussed within this presentation are hypothetical and have not been launched. They are still in the concept phase only. Since there is no live data for these concepts, the performance and data are back-tested based on the concept s methodology. In performing these back-tests, existing indices may have been used as underlying building blocks, and those existing indices may include live or back-tested history. The official history is used when available, however, based on the time period reviewed, back-tested calculations may have also been used. For any of the existing indices, the back-test calculations are based on the same methodology that was in effect when the index was officially launched. Complete index methodology for those existing indices are available at The inception date of the S&P 500 VIX Short Term Futures and S&P 500 Mid-Term Futures Index was December 22, 2008, at the market close. The inception date of the S&P 500 Dynamic VEQTOR Index was May 25, All information presented prior to the index inception date is back-tested. Back-tested performance is not actual performance, but is hypothetical. The back-test calculations are based on the same methodology that was in effect when the index was officially launched. Complete index methodology details are available at Past performance is not an indication of future results. Prospective application of the methodology used to construct the S&P GSCI Index may not result in performance commensurate with the back-test returns shown. The back-test period does not necessarily correspond to the entire available history of the index. Please refer to the methodology paper for the index, available at or for more details about the index, including the manner in which it is rebalanced, the timing of such rebalancing, criteria for additions and deletions, as well as all index calculations. It is not possible to invest directly in an Index. Another limitation of back-tested hypothetical information is that generally the back-tested calculation is prepared with the benefit of hindsight. Backtested data reflect the application of the index methodology and selection of index constituents in hindsight. No hypothetical record can completely account for the impact of financial risk in actual trading. For example, there are numerous factors related to the equities (or fixed income, or commodities) markets in general which cannot be, and have not been accounted for in the preparation of the index information set forth, all of which can affect actual performance. VIX is a registered trademark of Chicago Board Options Exchange, Incorporated. The VIX methodology is the property of the Chicago Board Options Exchange ("CBOE"). CBOE has granted Standard & Poor s Financial Services LLC ("S&P"), a license to use the VIX methodology to create the S&P 500 Short Term VIX Futures Index, S&P 500 Mid Term VIX Futures Index and S&P 500 Dynamic VEQTOR Index Series. The index returns shown do not represent the results of actual trading of investor assets. S&P Dow Jones Indices LLC maintains the indices and calculates the index levels and performance shown or discussed, but does not manage actual assets. Index returns do not reflect payment of any sales charges or fees an investor would pay to purchase the securities they represent. The imposition of these fees and charges would cause actual and backtested performance to be lower than the performance shown. In a simple example, if an index returned 10% on a US $100,000 investment for a 12-month period (or US$ 10,000) and an actual asset-based fee of 1.5% were imposed at the end of the period on the investment plus accrued interest (or US$ 1,650), the net return would be 8.35% (or US$ 8,350) for the year. Over 3 years, an annual 1.5% fee taken at year end with an assumed 10% return per year would result in a cumulative gross return of 33.10%, a total fee of US$ 5,375, and a cumulative net return of 27.2% (or US$ 27,200). 15

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17 Thank You Any questions please contact: Frank Luo Head of Global Research and Design 17