Is diversifying your portfolio by adding volatility as an asset a good idea?

In portfolio theory we teach students that investing in different assets improves the performance of portfolios due to the diversification effect. This effect works best if the correlation between assets is low or even negative.

Unfortunately, the correlation between assets, especially stocks, is quite high nowadays making it difficult to benefit from diversification. One asset being highly negatively correlated with the stock market is volatility. The most famous volatility Index is the VIX® Index which “is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices.” The correlation between the VIX and the S&P 500 is about -0.74 from the beginning of 2007 until today. So, it might be a good idea to add the VIX to your portfolio because of diversification, right?

Indeed, adding the VIX to your portfolio (10% VIX, 90% S&P 500) seems to significantly lower the volatility (12.4% compared to about 20% for the S&P 500) by giving up just a modest amount of return. Especially during the financial crisis the mixed portfolio clearly outperforms a pure investment in the S&P 500.

But although the chart looks appealing, it is impossible to construct the portfolio above. The problem is that the VIX is not tradable but only cash settled futures on the VIX. The closest to the spot price is the next terminating future which I call F1 from now. The maturity is less than one month and it is one of the most liquid contracts.

Instead of using the VIX for the calculation, the above chart shows what happens if you use the F1 contract which is tradable in contrast to the VIX Index. Although the F1 is only 10% of your portfolio it erases almost all gains of the S&P 500 since the bottom in 2009. Of course, your portfolio has still a much lower volatility (13.6% compared to about 20% for the S&P500) but your return is devastating making it a bad investment idea. Why are the results that different?

The reason is the characteristic of futures, more precisely the term structure of futures. VIX futures are usually in contango, meaning the term structure is concave (future contracts trade higher with longer time to maturity). For example, the VIX futures contract maturing in one week was trading about 9% above the spot price at the time of writing but at maturity this spread will drop to zero. In short, holding a futures contract that is in contango makes you, ceteris paribus, lose money as time passes by. We see this effect when using the F1 contract for our calculations. But is there still a possibility to benefit from the negative correlation?

Actually, there is some hope. The contango effect is less severe for contracts having a longer time to maturity if it is rolled monthly. For example, the contract maturing in April 2018 trades only about 3% higher than the contract maturing in March 2018. Accordingly to F1 I call the contract maturing in about seven months the F7 contract.

 

Using the F7 contract gives much better results being a lot closer to the results using the VIX directly. Adding the F7 contract (again with weight 10%) reduces the volatility by about 4 percentage points to 16%. The return is still lower than for the VIX example but it is much better compared to the F1 example. One can even slightly improve the results by only rolling the contract if VIX is in contango and keeping it if VIX is in backwardation.

Diversifying your portfolio by adding volatility as an asset might be a reasonable idea due to the highly negative correlation but you should be aware of the mechanism of futures markets. Simply using the VIX Index for your calculations is highly misleading because one cannot invest in VIX but only in futures on VIX. The contango effect will destroy your portfolio returns leaving you with a painful underperformance in good times and a disappointing performance in bad times. So, if you still want to add volatility as an asset to your portfolio it might be better to either buy mid-term contracts like F7 monthly rolled or to buy an exchange traded note (ETN) like ZIV instead of just buying the short term contract F1 or an ETN like VXX.

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