Long term pay off to selling volatility
After years of stability, the return of volatility to global markets in February 2018 saw those shorting it suffer substantial drawdowns. This led many investors to question the appropriateness of such a strategy. NN Investment Partners (NN IP) demonstrates the continued attraction of systematically selling volatility, regardless of the prevailing level of volatility, with expected returns exceeding losses over the long term.
Strengthening economic conditions and accommodative policies made last year the least volatile year in decades. The existence of the Volatility Risk Premium combined with the VIX ‘fear index’ dropping to a historic low, made the selling of volatility a rewarding strategy. However, in 2018 volatility returned with a vengeance. On 5th February, expectations of higher inflation and the spectre of increased Federal Reserve rate hikes caused the VIX to undergo its largest move in history. The resulting fallout led to the closure of the XIV (an exchange traded note which was short volatility and shut down after triggering a termination event) and an equivalent ETF (SVXY) lost almost 90% of its value.
However, NN IP shows that investors can still profit from systematically selling volatility. Such a strategy relies on capturing the Volatility Risk Premium, i.e. the difference between implied volatility (priced into options) and subsequent realised volatility. Buyers of implied volatility are willing to pay a premium as it enables them to transfer risk off their balance sheets, comparable to buying insurance while expecting, and often even hoping, it to generate a loss.
Stan Verhoeven, Senior Portfolio Manager Factor Investing and Solutions at NN Investment Partners assessed the historical difference in implied and realised volatility for the period 1990-2018, incorporating both periods of low volatility and market upheaval such as the Global Financial Crisis and the recent rout on 5th February. The results showed that the difference – and thus the pay-off generated by selling implied volatility – has been positive 86% of the time and averaged 4% over the period as a whole. The results demonstrate that buyers of volatility systematically overcompensate, providing an attractive opportunity for sellers and that the prevailing level of volatility is not indicative of future expected returns.
“Selling volatility comes with significant short-term risks, however long term gains should sufficiently compensate for future tail-risk events (unless you have a crystal ball). It is better therefore not to try timing the next tail-event, but rather take a long-term approach and manage the embedded risks by investing in a broader set of diversifying factors.”
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