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Eroding fortunes But there are a number of costs for receiving this type of black swan insurance cover. VIX futures are usually in contango, so they suffer from value erosion over time. The performance of the VXX ETN, which is based on these futures, has been dismal for most of the period since its launch in early 2009 (see ‘Rolling 30-day Returns - VXX, VIX, S&P 500’ graph on page 52). Much of the poor performance can be explained by the fact that the VIX has collapsed from the levels seen at the beginning of the year but, even compared with the VIX, VXX has significantly underperformed. It is important to note that volatility is mean reverting, so unlike most other asset classes, it does not produce a longterm return. Volatility can decline or remain at a low level for extended periods and by its nature is highly asymmetric, tending to quickly move higher over a short period and then gradually decrease over a longer period. This makes markettiming the asset class particularly difficult and as the ‘Rolling 30-day return’ graph on page 52 shows, VXX has offered a positive return for only a short period of its admittedly short track record. For these reasons, direct investment in volatility is often seen as more of a risk control/portfolio diversification tool than a standalone source of alpha. Just rewards The high cost associated with receiving volatility protection naturally means there is an opportunity to generate a high returns by being a provider of such protection. By taking a short volatility position, an investor can capture the premium associated with holding volatility risk. Given the large number of market participants wanting to hedge out tail risk by being long volatility, those who sell volatility insurance can demand a good price. This has enabled short volatility strategies to perform well for the majority of the past decade, but in 2008 they suffered catastrophic losses as the VIX reached a record high and liquidity in the variance swap market completely evaporated. Alternative path Beyond direct directional exposure to volatility markets, volatility trading hedge funds can offer investors an alternative route into the asset class. These funds will not necessarily be long volatility all of the time or even have a significant directional bias to volatility. Directional volatility plays involve market timing issues and often a relative value approach has the potential to offer superior performance. Some other Commodity trading advisors… thrive on volatility and perhaps offer the most attractive method to gaining long volatility exposure. [They] can also perform excellently in rising market environments “ ” hedge fund strategies, while not explicitly exposed to volatility are implicitly long volatility in that they often perform best when markets are volatile. Feeding off volatility Equity short-bias funds will provide excellent returns in market downturns, although by being short an asset that appreciates in value over the long term; the strategy is again more suited as a portfolio diversifier than a return enhancer. Commodity trading advisors (CTAs) are systematic trading strategies that thrive on volatility and perhaps offer the most attractive method to gaining long volatility exposure. CTAs can also perform excellently in rising market environments. The ‘Key black swan events’ table shows the performance of CTAs during the worst months for equity markets since 1987. Long volatility trades have been an unattractive proposition since the VIX began its descent from its record high in late 2008, but with a highly uncertain recovery ahead and the VIX back below 20, there seems to be a renewed case for protecting against the return of fear. Cheyne Fund specializes in credit market investments and has won or been nominated for numerous awards from 2003 until 2009, many for its long short credit funds.
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