Can Investing in Volatility Help Meet Your Portfolio Objectives?

Abstract

This research has investigated whether volatility exposure might contribute to achieving various portfolio objectives from the standpoint of an investor with an existing portfolio similar to the typical U.S. pension fund. The main message is that the response to opportunities in volatility markets should depend on investor circumstances. Shorting volatility, particularly onemonth variance swaps, offers the possibility of capturing what appears to be a substantial volatility risk premium. This benefit can come, however, at the cost of increasing the risk that the downside is exacerbated during equity market sell-offs, especially when the existing portfolio contains substantial equity exposure. Investors who are best placed to capture the volatility risk premium are likely to have lower risk aversion, longer investment horizons, and portfolios that are less heavily dominated by equities. The investors more likely to meet the criteria might have a secure basis of funding that is unlikely to be withdrawn during bouts of poor performance and, perhaps, investors who are funding interest-rate sensitive liabilities. Alternatively, long positions in products such as forward variance swaps and longer-dated VIX futures offer the prospect of hedging equity risk at little cost because they appear to contain minimal exposure to the volatility risk premium. Nevertheless, the efficacy of such hedging positions may depend on the prevalence of other objectives. Long volatility positions can add to the risk of underperforming for benchmark-aware investors, and could make little difference to outcomes under some liability-aware situations. Hence hedging positions may be of limited benefit in some circumstences, depending on the mix of objectives. Show more