The Benefits of Volatility Futures in Equity Portfolio Management

A number of studies suggest that volatility and equity returns tend to move in opposite directions (i.e. they are strongly negatively correlated) which allows for significant diversification benefits from adding a long volatility position to equity portfolios. The correlation between the VSTOXX and EURO STOXX 50 index return series is substantially negative at -0.74 for the sample period January 1999 to April 2011. During the recent 2008 crisis, the negative correlation between VSTOXX and EURO STOXX 50 indexes was particularly strong, estimated at -0.80 (the highest value so far) for the January 2008 to December 2008 period. These results suggest that the benefits of diversification with volatility indices manifest themselves when they are needed the most.

Guobuzaite and Martellini (2012) provide a formal analysis of the benefits of volatility derivatives in equity portfolio management from the perspective of a European investor. They explicitly compare managed volatility strategies based on GMV (Global Minimum Variance) portfolios and managed volatility strategies based on volatility derivatives. Their results unambiguously suggest that the latter approach is a more efficient way to manage equity volatility, especially in market downturns periods.

In order to invest in VSTOXX, an investor may take a position in VSTOXX futures and/or options contracts. Mini-futures on VSTOXX were introduced on the Eurex Exchange in June 2009, with a contract value of €100 per index point. Considering that an individual futures contract is traded for limited time only, an investor has to roll over the initial VSTOXX investment over the series of consecutive futures contracts for a long exposure in VSTOXX. They constructed three separate VSTOXX futures series based on different rollover methodologies: 1-month, 3-month and longest-traded (LT) series. The purpose of this exercise is to analyse the costs associated with different rollover strategies as a function of the frequency of rebalancing. They have estimated that during the analysed sample period from April 2008 to April 2011, the VSTOXX futures market was approximately 79% in contango and 21% in backwardation. As a result, a rollover strategy typically induces a negative return.

They construct several equity portfolios with increasing allocations to VSTOXX futures positions. The European equity market exposure is approximated by the investment in the EURO STOXX 50 Index. The investment in VSTOXX is represented by a fully collateralised VSTOXX futures position. The analysis starts with the pure equity portfolio as a benchmark case and adds, in 5% increments, a long volatility exposure to the portfolio. The results for the best performing 3-month VSTOXX futures series are presented in Figure 1, in an efficient frontier format. The best performing portfolio is achieved by allocating 30% to STOXX futures.

Figure 1: Impact of Adding Long Volatility Exposure to Equity Portfolio in 5% Increments

The diversified portfolio with VSTOXX futures proves to be a better investment opportunity than the GMV portfolio. Firstly, it improves the standard deviation of returns from 21.6% (for GMV portfolio) to 16.1% p.a. (for diversified portfolio); secondly, it also reduces negative returns for the sample period – from -2.8% (GMV) to -1.0% p.a. (diversified portfolio). In summary, there are benefits of adding a long volatility exposure to equity portfolios with volatility futures contracts. Careful attention to trade execution is nonetheless required to limit the negative impact of transaction costs, negative carry and roll yield on volatility futures during normal periods.