Forum. Protection Strategies: Thinking beyond the VIX. A meeting place for views and ideas. Thomas Gillespie PhD, Director, Investment Risk Advisory

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1 Forum A meeting place for views and ideas Protection Strategies: Thinking beyond the VIX Published September 2012 Authored by: Thomas Gillespie PhD, Director, Investment Risk Advisory Scott Maidel CFA CAIA FRM, Senior Portfolio Manager, Equity Derivatives Adam van Ness CAIA, Head of Implementation, Australia and New Zealand

2 Derivative practitioners spend a lot of time talking about volatility, skew, smile, gamma...the most important issue is the price of the option bought or sold and the protection gained or upside given up. Protection Strategies: Thinking beyond the VIX Prior to recent weeks, the widely followed VIX had only rarely fallen below 15 in the last five years. This Forum is to help investors better understand what the VIX is telling us at this time, some protection strategies that make sense given current markets, and, importantly, how Russell can help to implement them. What is the market telling us? Now might be the time to think about implementing protection strategies. In the last weeks we have seen the VIX dip and stay below 15, which takes us back to the exhilarating days of We have not seen these levels, but for a few days, over the last five years, and the level is telling us the market is pricing risk in the low range of expectations (see Figure 1). This has been confirmed with other market indicators such as credit spreads and the level of the AUD/USD a classic risk asset. Figure 1: VIX through market cycles Jan 1986 Jan 1988 Black Monday VIX = 150 Average VIX=21 US Recession VIX = 35 Jan 1990 Jan 1992 Bond Market Sell off - VIX = 20 Jan 1994 Jan 1996 Asian Market Risk VIX = 37 LTCM VIX = 45 Jan 1998 Tech Bubble VIX = 34 Jan /11 aftermath VIX = 43 Jan 2002 Subprime Credit Crisis & Lehman Failure VIX = 80 Iraq War VIX = 45 Jan 2004 Stable Rising Equity Markets VIX 10 Jan 2006 Soverign Debt Crisis VIX = 40 Current level VIX<15 Jan 2008 Jan 2010 S&P US debt downgrade & Euro Debt Crisis VIX = 48 Jan 2012 Source: Russell Investments 18 September For illustrative purposes only. Prior to 1990 the CBOE OEX Implied Volatility (VXO) has been used. Between 1990 and September 2003 the original VIX has been used as the methodology was changed at that time. This bullish sentiment is at odds with the macro risks in the market (potential Europe breakup, China slow down and inflation fears, on-again-off-again US recovery, US indebtedness, to name a few). And then there are the contributing factors to support much stronger equity markets cheap equity markets, particularly in Australia, and extremely low bond yields. 1 The VIX is a volatility index of short-term US equity (S&P 500 index) implied volatility derived from traded prices for exchange listed options and published by the Chicago Board Options Exchange. The VIX is a widely followed measure of investor uncertainty and is actively traded through exchange traded futures and options. Standard & Poor s Corporation is the owner of the trademarks (S&P 500 and ), service marks, and copyrights related to its indexes. es are unmanaged and cannot be invested in directly. 1

3 Derivatives: Demystified and De-jargoned! Given the typical Australian Balanced/Growth style defined contribution superannuation plan with 5-7 growth assets derives 80-9 of its total investment risk from equity factors, let us concentrate on equity protection strategies. The simplest derivative protection strategy is to buy a put and let us keep it simple by considering index put strategies which are the cheapest way to hedge a portfolio and generally the most liquid. An index put option at the pre-determined expiry date is valuable if the underlying index is below the fixed strike price and theoretically directly compensates for the loss of holding index exposure. Figure 2 shows a typical pay off diagram of the overlay strategy of buying a put against existing physical holdings. Derivative markets spend a lot of time talking about historic volatility, implied volatility, skew, smile, term structure, delta, gamma... But the most important issue for end users is the price of the option bought or sold and the amount of protection gained or upside given up this is exactly what is shown on a payoff diagram where the derivative strategy wins and losses. A straight forward cost benefit exercise without a mathematical formula in sight! Figure 2: Put option payoff Put option strategy underperfroms physical only strategy as put options are worthless at expiry if index is below strike (4050 in this example) and premium is paid upfront Put option strategy outperfroms physical only strategy as put options have positive value at expiry if index is below strike (4050 in this example) Physical equity equity exposure Source: Russell Investments. For illustrative purposes only. As an aside, there are a couple of things to note: Put protected exposure A) When looking to protect equity positions, it generally makes sense to buy longer dated options rather than shorter dated. D) Each individual investors portfolio is different and objectives/risks are different an off the peg unmanaged solution probably will not be the best solution in terms of cost and effectiveness. With the VIX trading at 15 and lower there are a variety of choices for hedging. But firstly the VIX is a measure of price for the short dated S&P500 options traded on the Chicago Board Options Exchange. It does not tell us where the longer term options are priced and does not tell us about option prices in other markets. Put and put spread based strategies Equity index put based strategies are appealing for a number of reasons: they are simple, the upfront and final cost is known, they are a direct hedge, they don t rely on historic relationships holding in the period of a crisis, and are some of the most liquid derivatives in the market. Put strategies do have an element of tracking error for active portfolios that do not perfectly track the underlying index but the upside is that any alpha generated by active managers is preserved. Indirect hedges such as VIX futures, volatility derivatives and dynamic asset allocation have merits but the appeal of put based hedges is they are direct, the cost is know upfront and they do not rely on historic relationships for the protection. What the VIX does not tell us is the cost of put protection the price will vary with the time to expiry, the strike price, and from market +4 to market. Figure 3 shows the cost of 1 year, 9 puts over (Australia) and S&P500 (US) +3 over time. This +2 data shows, despite the recent declines in option prices, the cost of protection is not inconsequential. +1 A number of strategies of mixing both bought puts and sold put and/or -1 calls can give rise to a cheaper protection strategy, but -2 are usually conditional rather than absolute -3 protection. With such collar strategies the upside is capped in exchange for typically zero upfront cost. The payoff diagrams -4 for a couple of strategies Physical are equity shown equity in exposure Figure 4 the collar strategy and the put spread Collar protected collar. exposure The relative pricing of these strategies vs. the standard put strategy also varies over time, and is typically driven by supply and demand. In the current market, put spreads and put spread collars are preferred over both outright puts and collars due to the relatively lower cost or funding the upfront cost by selling some upside potential B) The converse is true when extracting greater yield, it is usual to sell shorter dated options and roll frequently. C) As not all stocks in a market are perfectly correlated, index options are generally cheaper than a basket of stock options and a whole lot easier implement! 2 For an explanation of some of these terms and derivative market jargon please see Rae D. & Maidel S., Equity Volatility and Implications for Option Strategies, Russell Investments Research Report, May 2012, and Collie B., Basic Greeks: Essential knowledge for investors considering options, Russell Investments Research Report, April

4 Figure 3: Historic Put Pricing 16% 90 Cost of 1 year 9 Total Return Put 14% 12% 1 8% 6% 4% 2% Put Price: Put Price: S&P 500 VIX VIX Jan 1990 Jan 1992 Jan 1994 Jan 1996 Jan 1998 Jan 2000 Jan 2002 Jan 2004 Jan 2006 Jan 2008 Jan 2010 Jan Source: Russell Investments 18 September For illustrative purposes only. Figure 4: Other Option Strategies Physical equity equity Physical exposure equity equity exposure Physical equity equity Physical exposure equity equity exposure Collar protected Collar exposure protected exposure Put spread collar Put protected spread collar exposure protected exposure Source: Russell Investments. For illustrative purposes only. 3

5 VIX futures or VIX based derivatives In the last 10 years we have seen the rise of VIX futures and options, volatility based exchange traded funds (ETFs) and complex structured products. Many investors now use these tools for protection strategies. But these are not without their issues when considered as physical equity protection strategies.»» Roll cost: The VIX is not investible and so protection buyers are exposed to roll cost for futures. In most market environments, short dated VIX futures trade at a price less than the further dated futures (known as a contango market) this implies VIX futures are expensive to roll. Consequently, since the ipath S&P 500 VIX Exchange Traded Notes (ETN s) were listed in January 2009, the short-term contract has lost 95% of its value (total return basis, ticker VXX, based on 1 month VIX futures rolls).»» Effectiveness lost by rolling longer dated futures: One strategy investors and structured product providers use to avoid this roll cost is to roll longer dated VIX futures. But this has only reduced the roll cost, and longer dated VIX futures respond less quickly than shorter dated VIX futures and the VIX index itself. For example mid-term the ipath S&P 500 VIX ETN contract has lost only 6 of its value since January 2009 (total return basis, ticker VXZ, based on 5 month VIX futures rolls). In broad terms, the short dated VIX ETN is half as responsive to equity moves as the VIX index itself and the longer dated ETN is half as responsive again in essence rolling longer dated futures still has a positive roll cost and it is far less effective as a hedge.»» Not a direct hedge: For hedging equity risk, VIX strategies rely on historically observed correlations persisting in periods of crisis when the protection is most required. Analysis has shown the relationship between equities and the VIX to be highly variable and fundamentally broke down in the period when needed most. Moreover the popularity of VIX futures and options since 2010 has raised questions about the capacity of the market to accommodate rolling of positions and the potential unwinding of positions in periods of crisis to capitalise on the generally higher VIX levels. Effective structuring and implementation is crucial Effective structuring and implementation of any of these strategies is crucial to their success. Structuring the protection strategy is usually the first step, and starts with a careful consideration of the portfolio and investment objectives (risk objectives as well as the more common return objectives), investment horizon, risk budget, maximum loss tolerance and so forth. Crucial to the question of sizing of hedge positions is a full understanding of the risks: How well do the assets hedge the liabilities/objectives? How much diversification is there within the assets? How much equity beta is there in the alternatives portfolio? Secondly, implementation is another key issue. Derivatives trade on and off exchange and it is important to understand the availability and liquidity of these alternatives both before the hedge is entered into but also under various market conditions to include the possibility of early termination or rolling of positions. For options traded off exchange, specialised documentation is required and competitive tenders must be held to ensure the best pricing is achieved. Moreover, if put options are bought off exchange then potential counterparty risk is a very real issue especially for protection strategies because as equity indices decline, the puts become valuable, but also credit worthiness of typical counterparties weakens considerably. Counterparty vetting and diversification, as well as actively reducing counterparty risk with a daily margining process are essential. Russell s structuring and implementation expertise Russell has the expertise and ability to structure and implement protection strategies. Russell s risk advisory service is well placed to analyse fund holdings and liabilities/ objectives, and to work with clients to structure the hedging strategy that meets client needs and satisfies the client s unique set of constraints. Russell s implementation services are also uniquely placed to act as fiduciary for clients to implement protection strategies with transparent cost, and an unconflicted ability to execute at the best price attainable and with only a client s best interest in mind. Russell has a strong local and global presence to offer clients the best service locally based on the best global thinking. 4

6 For more information contact Russell: Phone Sydney Melbourne Website Address Level King Street Sydney NSW 2000 Thomas Gillespie Director, Investment Risk Advisory, Russell Investments tgillespie@russell.com Adam van Ness Head of Implementation Australia and New Zealand Russell Investments avanness@russell.com This document is issued by Russell Investment Management Limited ABN , AFS License (RIM). It provides general information for wholesale investors only and has not prepared having regard to your objectives, financial situation or needs. Before making an investment decision, you need to consider whether this information is appropriate to your objectives, financial situation or needs. This information has been compiled from sources considered to be reliable, but is not guaranteed. Past performance is not a reliable indicator of future performance. Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. Copyright 2012 Russell Investments. All rights reserved. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from RIM. R_NEWS_Forum_Protection_v1F_1209 MKT/ 4874/0812