VIX as a Companion for Hedge Fund Portfolios

Abstract

Volatility in general, and VIX in particular, is widely thought to influence hedge fund returns. This article shows that not only is VIX negatively correlated to hedge fund returns, the correlation profile is asymmetric with the correlation being more negative in negative months for hedge funds. When hedge funds are delivering the worst quartile returns, the diversification benefit is best. Equally interestingly, when the diversification or protection is least needed, i.e. in highest quartile months, the correlation is positive. It is explored whether a small allocation to VIX can be constructively used for risk reduction or downside protection in broad based hedge fund portfolios. Standard mean variance measures suggest a static allocation of 0% to 10%, which is consistent with the common sense approach of allocation only a very small portion of the portfolio to volatility. This range, together with the mean reverting property of VIX, and the asymmetric correlation of VIX and hedge fund returns is used to explore a tactical allocation strategy that outperforms a simple static allocation of VIX or a portfolio with no VIX allocation on a risk adjusted basis, while reducing downside risks.