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Monday, January 3, 2011

Report Card on The Black Swan Hedge

Even with the strong stock market this year, the rise of optimism and consequent sharp decline in the VIX, a hedged portfolio composed of vxx and vxz dragged down only moderately even this year.performance this year. The vxx was particularly hard hit as the contango really generated a big hit. My rough calculation is that a mix of vxx and vxz equal took down a diversified portfolio of "risk assets" (global stocks and some commodities) by around 2%.

For a portfolio composed of 95% sp 500 2.5% vxx and vxz the portfolio total return was 12.1% vs 15.1% for 100% sp 500. And the portfolio volatility was reduced from sp 500's 18% to 15.1% for the hedged portfolio. In other words in a bad year for the hedge (strong underlying market, decline in implied volatility=vix) the hedged portfolio performed exactly as one would expect: lower return and lower volatility vs 100% stocks unhedged, (chart below)

I would venture to guess that many people that tried to time the market, particularly those that moved to medium or longer term bonds suffered   a bigger drag on performance. A 20% AGG aggregate bond index /85% sp 500 portfolio would have returned 13.3% with 14% volatility. Not a big improvement considering the volatility hedged portfolio has better risk/reward characteristics should bonds continue to reverse or if stocks sold off sharply.

Looking at an alternative "black swan " edge in the options I still would go for the vxx/vxz. A 10% out of the money (110 strike with the sp 500 at 1257.64 closed the year at  25.20 which would be 2% for six months and remember unlike the volatility etns this has a high probability of expiring at zero in fact according to option pricing theory a 50% chance of expiring worthless.

So I would say the report card for the vxx/vxz hedge in a particularly bad year was a low B. A higher proportion of vxz to vxx  rather than equal weight going forward And of course those that initiate the hedge now are buying into very low vix levels, not to say they cant go lower.

Some of the new volatility related products which have various mechanisms that could moderate the impact of the contango in the futures are intriguing and worth examining later.

1 comment:

Zevon said...

You advise: "to avoid the vxx completely when the futures mkt is in deep contango."

Exactly how do I know when this is?

I (hoped) imagined that the VIX might get as low as 15 by the end of this month; providing an opportunity to go long vxx without getting my face torn off as I had already experienced.

Will establishing a vxx position either: Today Or - at the end of January expose me to this hellish contango?

To the best of your judgement - you advise 3% VXZ + 2% VXX at this time?

Better than equal weight?
What about the reverse?
Or 4% VXX + 1% VXZ + either
1% XVV or 1% XVIX??

I am not at all joking - I sincerely need effective 'buy and hold' protection but can not even comprehend 'contango'.
So your judgement is invaluable to me.

Profound thanks and -
Very Warmest Regards,