A week ago, doom and gloom headlines abounded as the VIX Index spiked 46% and the S&P 500 Index crashed, falling a panic inducing 1.79%! Hopefully, my sarcasm is evident, but in case it’s not – I am being sarcastic. It is always amazing to me how recent market behavior can influence our psychology, and usually not in a positive way.
Looking historically, the S&P 500 Index has fallen more than 1.7% in just over 6% of all days since January 1, 2000. This is an average of just over one time per month. However, until last week, it’s been since September 9, 2016 since we’ve had a loss of that size, thus leaving us all with the impression that the market was “crashing” even though a loss of that magnitude is historically a common event.
Realistically, most investors probably recognized that the market wasn’t really crashing, but may have been very concerned by the “VIX is up 46%!” headlines. This is especially true given all the recent talk of the VIX at historical lows, implying that it can only go up from here, and that short bets on the VIX are doomed (we’ve also spilled ink over VIX lows). While the VIX will eventually revert, investors need to understand how costly and difficult it is to gain direct exposure to the inevitable reversion.
Not to pick on Bloomberg, as there were plenty of choice headlines, but they published an article entitled “VIX Surge Is Unwelcome Lesson in Duplicity of Volatility Wagers” which began with the following paragraph:
- It finally happened. After months of speculation over when the lull in U.S. equity volatility would snap, investors got their answer Wednesday. A bombshell report on President Donald Trump’s interactions with former FBI director James Comey sent the VIX up the most in almost a year. For anyone on the wrong end of the trade, it was a painful lesson.
Maybe that’s true, but probably not nearly as painful (or joyous for those positioned to benefit from an increased VIX) as many might think.
An investor who timed the trade perfectly (or imperfectly) would have gained (or lost) 18%, not the often alluded to 46%. This is because the VIX is not directly tradeable and must instead be accessed via derivatives (futures, options or exchange traded products investing in futures such as VXX). I’ll save the details for why the VIX and VIX-related instruments behave so differently for a future post; just know that the often quoted VIX movement typically has a much different impact on investors.
Above was the one day return, but few people are only trading these vehicles for one day, so I thought a few more charts could be helpful. For example, what did an investor make holding VXX for one week rather than one day?
Not much (2.65%)… How about an investor who bought at the end of April?
Painful (-7.00%)… How about an investor who perfectly timed the VIX bottom on May 8th?
Even the investor who perfectly timed the low lost nearly 1% on the trade if they held it through yesterday. This illustrates just how hard it is to make a profit via an explicit long volatility position. Why does this matter? Because investors need to understand that assets with true negative correlation to equity markets are extremely expensive (in the form of negative expected return) and almost impossible to monetize.
A more prudent approach may be to find strategies and assets with little to no correlation to equities with the understanding that they may not profit every time the market goes down. Even better is to find assets with a high probability of profiting through an extended crisis. Our admittedly biased opinion is that managed futures (both trend following and counter-trend strategies) provide a low cost diversifier with the additional benefit of providing the much sought after “crisis-alpha”.
Read our related blog, Crisis Alpha?