CIO Insights: Using Volatility as a Diversifier

Using volatility as a diversifier

In recent editions of CIO Insights, we’ve written about the return of risk to financial markets and the implications for individual investors. This time, we want to talk about how we hedge portfolio risk with a direct investment in securities tied to volatility, which has certain characteristics that make it a potentially very useful portfolio diversifier. However, positions in volatility-linked securities can be costly and are probably best left to your financial advisor, or held in the context of a professionally managed, diversified portfolio.

Read Wittman’s full Q2 2016 CIO Insight:
Using Volatility as a Diversifier

Volatility Defined

Volatility comes in two forms. One refers to the realized or historical standard deviation of an asset’s returns—it is a measure of asset price movements in the past. This historical volatility is what commentators are talking about when they say that “stocks are more volatile than bonds,” for example.

The other usage—and the one that concerns us here—relates to expected volatility, as expressed by the VIX Index. VIX, commonly referred to as the stock market “fear gauge,” is derived from option prices on the S&P 500® Index. This makes VIX a handy measure of investor sentiment at any given time. When commentators say that volatility in the market is rising, they are talking about VIX, and the fear and uncertainty around the outlook for stocks that it represents.

Important Caveats

When talking about volatility as an asset class, or as an investment with portfolio benefits, it is important to first lay out some caveats. One, volatility is in fact quite volatile—VIX is about four times as volatile as the S&P 500 itself. Two, volatility has no fundamental value of its own—no earnings, yield, or underlying net asset value. Finally, VIX itself is not directly investible, so investors who want volatility exposure must use often expensive futures, options, or exchange-traded products to gain exposure.

The “Value” in Volatility

Volatility’s “value” comes entirely from its negative correlation with stocks: When one goes up, the other has historically gone down, and vice versa. Or think of it this way: When investors are fearful, VIX rises, and when investors are complacent, VIX declines. Crucially, the negative correlation has been greater on days when stocks fall than on days when stocks rise. This makes intuitive sense—investors are more fearful when stocks decline than they are when stocks are rising.

Volatility diversification is appealing in this context precisely because it holds out the possibility of reducing risk in a more efficient manner than do many traditional portfolio diversifiers. These characteristics make VIX a potentially effective hedge for equity risk as a small part of a larger, diversified portfolio.

Professionals Only

Our own analysis on this topic leads us to conclude that a systematic approach to volatility trading can succeed and offers significant potential benefits to investors. But because of the complexities and dynamism of the market for VIX futures, we would argue that the attempt to trade volatility be left to sophisticated investors with the tools and flexibility to take informed, active positions in volatility as opportunities arise—do not try this at home.

Diversification does not assure a profit nor does it protect against loss of principal.

The opinions expressed are those of Scott Wittman, CFA, CAIA, and are no guarantee of the future performance of any American Century Investments portfolio.

For educational use only. This information is not intended to serve as investment advice. Past performance is no guarantee of future results.