The Different Faces of Volatility Exposure in Portfolio Management

Abstract

This article analyzes the different forms and features of equity volatility exposure and reviews the merits of incorporating equity volatility exposure in portfolio management. The main goal is to show the diversification power of tradable equity volatility-based products, such as VIX futures and products based on VIX futures indexes, and to compare their value in a risk-management context with other strategies traditionally used for modifying investment risk. Features examined include correlation and tail-risk properties, betas to the VIX and S&P 500, and the impact of rolling futures positions on returns. Different investment applications of short-term and mid-term VIX futures and VIX futures indexes are reviewed and the risk–return characteristics of these forms of volatility exposure are compared to those of other risk-modification strategies. The analysis shows that for investors with longer term investment horizons, mid-term VIX futures and futures indexes have the most attractive features for managing risk and are more capital efficient than fixed-income. However, the main significance of the analysis from a portfolio management perspective is that volatility exposure is a viable and attractive alternative to adding cash-equivalent and fixed-income exposure for reducing risk.