Analysts say 'perfect hedge' is on its way
VIX futures track volatility
Steve Maich
Financial Post
Thursday, December 04, 2003
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Grumpy market cynics will tell you the only perfect hedge is in a well-groomed garden, but futures traders think they may have found a hedging instrument that comes close to perfection.
Starting in January the Chicago Board Options Exchange plans to introduce a futures contract based on the S&P 500 options volatility index, better known as the VIX. And if the VIX futures are a hit with investors, other VIX-based derivative products could soon follow.
And for investors growing concerned about the sustainability of the current market rally, such products can't arrive soon enough. The VIX hit a low of 15.77 yesterday, its lowest point since 1996, and history suggests that now would be a good time to bet on a return of volatility to the markets.
Strategists at Merrill Lynch & Co. have delved deeply into the volatility numbers, and are hailing the new VIX futures contract as an "important piece of financial innovation" that could be a useful tool for investors to manage risk.
Benjamin Bowler, Merrill's equity derivatives strategist, issued a report yesterday detailing how a portfolio based 90% on the broad S&P 500 index, with a 10% weighting in the VIX index, has outperformed the market by 5% a year with substantially less risk over the past 17 years.
"Equity volatility appears to be almost a perfect asset for equity holders to own," Mr. Bowler said in his report.
The main reason for this enthusiastic endorsement is the fact that the VIX has been strongly negatively correlated to the broad stock market over many years, and that is a key advantage for any investor looking to protect themselves from market falls.
The whole notion of diversification is built on the desire to have a collection of assets that don't move in lockstep.
For generations investors have tried to mitigate their risk by investing in growth stocks, value stocks, bonds, and gold in hopes of making decent returns in virtually any market.
But no other asset class exhibits the strong negative correlation that the volatility index does.
For example, while gold may tend to perform well in poor markets, that's not always the case. This year has provided a vivid example of that, as gold has risen 16.3% while the S&P 500 has gained 21%.
But when stocks are rising, volatility is almost always falling, and vice versa.
This negative correlation provides what Mr. Bowler calls "crash protection." In the event of a sudden market plunge, volatility tends to spike sharply higher. So an investor with even a small portion of their portfolio in the VIX index would avoid major losses in the event of a market crash.
During the last major market crash, in October, 1987, the VIX spiked more than six-fold on the day that the S&P 500 plunged 28%. As a result, a portfolio weighted 90% to the broad index, and 10% in the VIX would've actually seen a 20% gain on the day of the crash.
But, as with any complex derivative security, there are pitfalls. For one thing, futures can be misused to ratchet up leverage, leaving the buyer exposed to massive losses if things go wrong.
Also, the new VIX futures won't precisely mirror the movements of the VIX index, because they will be based on implied volatility 30-days in the future. That means each contract will, in effect, be a bet on where the index will stand in a month.
And if the contracts don't catch on quickly, they could prove to be illiquid and difficult to trade.
Understandably, not everyone is convinced they'll fly.
"I just think it's way too esoteric for the average investor to get involved with, and there are lots of other ways for professional traders to hedge their risk," said one U.S.-based strategist.
But Alan White, professor of investment strategy at the University of Toronto's Rotman School of Management said if the VIX futures can replicate the index's negative correlation to the stock market, they could emerge as an important tool for large and small investors looking to hedge their bets.
"Risk management has been king for the past couple of years," Mr. White said.
"This is the virtue of a lot of the hedge funds, that they're not correlated with the market. So, if [the VIX] is negatively correlated it could be great for risk management."
smaich@nationalpost.com |
