Exploring Volatility As An Asset Class

For purposes of clarity I will use vol to refer to the asset class and volatility to refer to effect and impact. 

Making changes to client portfolios' overall volatility through the duration of a stock market cycle predates when I started blogging in 2004. The ways in which I do that have evolved over that time. Many years ago I made the very obvious observation that increasingly sophisticated investment products would make it easier for advisors and do-it-yourselfers to create very sophisticated portfolios. 

There are plenty of investment products that one way or another could be thought of as accessing volatility but do so in very different ways some of which might make vol an asset class to allocate to and some of which don't offer the diversification you might hope for by adding an asset class to your mix. To my way of thinking, to fit the bill of being an asset class, it should offer some sort of diversification benefit or attribute when measured against an equity allocation.

Certain funds and stocks when added to a portfolio can either increase or decrease volatility, here's a good example with ARKK.

No secret that the fund is wildly volatile, but does its volatility offer attributes of a different asset class? I don't think of a volatile stock or stock fund as being vol, the asset class. ARKK and holdings like it tend to correlate to equity indexes but with much bigger swings. If the correlation is high then adding something like ARKK increases volatility but does not offer diversification benefits to a primarily equity based portfolio. If ARKK looked nothing like the index but was that volatile, then maybe that would be a source of vol.

 

HDGE is the AdvisorShares Ranger Equity Bear ETF. Like ARRK, clearly more volatility than the S&P 500. Sometimes HDGE is as volatile as ARKK and by design, it looks nothing like the S&P 500. So adding a lot of volatility with a negative correlation certainly offers diversification benefit that ARKK does not. So this sort of holding could be one way that vol is an asset class.  

VIX products are an obvious type of product to consider for vol. We looked at these recently. Most of them are very difficult to hold onto. VIX funds that target short expirations have the tendency to go down 99%. Most of the VIX funds offer asymmetric potential to skyrocket but you need to time a crash in order to get the full benefit of that asymmetry. Odds of doing that aren't so hot. An exception that we looked at last month might be the ProShares VIX Mid-Term Futures ETF (VIXM). It doesn't go down 99% and you can see this year it has gone up nicely.

 

VIXM's chart for this year looks almost identical to client/personal holding BTAL and to a lesser extent but still similar to client/personal holding BLNDX. The key to me is that although the results are similar between the three, the strategies are entirely different which greatly reduces the odds of the same thing going wrong hurting all three at the same time versus buying managed futures from three different fund companies. I do consider VIX strategies as being vol, but I think only VIXM is one I would consider to add in a similar way that I might add an inverse index fund. If a purchase of VIXM ever comes to me I will share the details. To be clear, BTAL and BLNDX are not vol.

Tail risk funds seem like vol to me. Client/personal holding Cambria Tail Risk ETF (TAIL) and Simplify Tail Risk ETF (CYA) are the only two that I know of in this group but there are multi strategy funds that include tail risk. TAIL and CYA are simple exposure to the strategy. TAIL was helping more earlier in the bear market when the declines were a little faster than they are now. They can help in a bear market but the convexity of the puts might make it more of a crash strategy (that doesn't appear to decline 99%) than a protracted bear market strategy.

Some things that I don't think fit the bill of vol even though volatility is part of the strategy. First, covered call funds. This can be tricky though. If you read the literature on most of them, they talk about trying to capture the upside of the stock market but with a volatility dampener in the form of the call income. If they are trying to look similar to broad equity exposure then I don't think that is a vol story. To the extent they fail to track the stock market, that doesn't make me want to use them as vol proxies.

The buffer ETFs? No. They cap the upside and give all the downside below the buffer. If you buy a 9% buffer and the stock market cuts in half, yes the first 9% is spared but you feel the rest of the ride down. The website listing the buffer funds tells you how much of the buffer is remaining before you start to participate to the downside. They appear to do what they are supposed to but I don't want what they are supposed to do. 

Simplify has bunch of different ETFs that use option strategies. I've been underwhelmed by them. This chart is the Simplify US Equity PLUS Downside Convexity (SPD) compared to the S&P 500 YTD.

 

It's actually down more than the index somehow. SPD owns an S&P 500 ETF and is net buyer of puts with some long put positions and a couple of debit put spreads. If I was favorably disposed, I am not, I wouldn't think of them is vol, more like close to regular equity exposure with safeguards. Nothing wrong with that idea but that's not what I would be looking for to add vol as an asset class. 

I mentioned in passing the other day about having very recently added a fund that I would say uses volatility to be a vol proxy, the Princeton Premier Income (PPFAX). The general idea is that it sells out of the money put spreads on the S&P 500 using weekly expirations. The process for determining how far out of the money is kind of complex but the short version is it assess volatility using four different metrics and goes with the one of the four that is most conservative (typically the furthest out of money). The result is an absolute return profile that looks a lot like merger arbitrage and it can also be a fixed income proxy (fixed income like what investors hope fixed income will do, not what it has been doing lately). So it's an alt that looks like merger arb but uses a completely different strategy than merger arb to achieve that result. 

Part of this latest impetus to consider volatility as an asset class comes from the Cockroach Portfolio (linked above) which allocates either 20 or 25% to volatility (read the post for that to make sense) and from the Return Stacked 60/40 Absolute Return Index which has a much smaller allocation to volatility.

I would target sizing to volatility the way I target other alternatives/diversifiers which is the belief that a little bit goes a long way. My preference is to build up an allocation to diversifiers with several 2-3% weightings. Any of these can "not work" for some random decline or bear market and small allocations reduce the impact of one of them not working. Also an important point that I repeat all the time is that if you need normal stock market growth to make your financial plan work, then you need to maintain something of a normal allocation to equities because that is the asset class that goes up the most, most of the time. Alts hedge an equity portfolio, you don't want an alt portfolio hedged with a some equity exposure unless your in game over mode but even then, I would want to spread out the alts exposures.