Investing in Volatility

Paul Justice: Fix one leak, and another springs. I'm Paul Justice with Morningstar, director of ETF research. Today I'm joined by Bradley Kay, and we're here to talk about rising volatility in global markets in the wake of what was an apparent fix for Greece.

We're seeing market fears now spread across not only Europe, but all the way into Asia. If you could, please help us figure out an answer as to why this volatility is spiking now, and what kind of systemic problems do we have.

Bradley Kay: It certainly seem so surprising, especially for someone who's been paying attention to the more positive news that's been coming out of the U.S. economy recently.

But on the other hand we have, in Korea especially, there's been very much rising political tension, which has ignited a bit of a powder-keg economy we've already had there with the situation in Europe. So, Greece especially coming inches away from default, then that possibly leading to contagion throughout the rest of the Mediterranean region. Italy's not on great standing. Spain and Portugal, certainly there was even, today, a great deal of concern about them.

The stock markets did very poorly. It really seems to be that even though people thought that this package might do the trick, that this 700 billion euro rescue package might do the trick, the markets don't seem to be believing it right now.

Justice: Sure. It almost leads to global inflation fears. It used to be that the dollar was pegged as the weak currency that everyone would flee. The euro was very popular. But now we see the structural weakness emerge there, just as the U.S. ceases doing its own monetary expansion policy.

Now Europe seems to be following in the same, and it's leading to weakness not only in that region, but it's spread across the globe at this point in time. If we throw in the political fears, geopolitical, possibly warfare, it's leading to a great deal of instability, and it's also spreading across, not only in U.S. capital equity markets, but also in the bond markets at this point in time.

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Kay: Absolutely. It's just that today no economy is an island. The island economies, if anything, are the ones that have the greatest connections with everywhere else in the world. Even if you have a region which has had locally some quite good news, it can very easily be shocked by news from outside.

Justice: Given the increased volatility in markets, what are some of the choices for investors? How can they address this volatility to make sure that their portfolio isn't overly damaged from it?

Kay: Well, the unfortunate first response is the classic "I told you so, " which is diversification. Now may be...

Justice: Setting your risk tolerance with the asset allocations, stocks versus bonds.

Kay: Exactly. Knowing that you have enough cash. Unfortunately, right now this would require a little bit of selling out while you're down to try and actually build up that cash stake. It tends to be one of the biggest drags on investor returns overall is actually exactly that behavior, diversifying after the fact. What can be done right now though? You can even do some direct investments in volatility itself.

Justice: So we're looking at investing in volatility; a couple of choices really come to mind. I think a common strategy is a covered call strategy or a buy-write strategy. If you could, just walk people through how that strategy goes and why it's desirable in high periods of volatility.

Kay: With a covered call, essentially what you have to bear in mind is that when you write an option, when you sell an option to somebody, you are essentially buying volatility. You are writing something that will then have a higher value as volatility increases.

Justice: As opposed to going down in value with volatility spikes, which is what equity markets typically do. That's why they call them crashes.

Kay: Yes, exactly. So right now when volatility is extremely high, you are able to get a very high price for any options that you write. A buy-write strategy means buying the underlying stocks. In many cases, it's the equities that you already own if you own a large basket such as the S&P 500, MSCI EAFE.

Justice: You can do it on an ETF.

Kay: Yes, exactly. You then sell options that are, say, 10 percent out of the money, 20 percent out of the money, co-options in particular. You are capping your upside, but on the other hand, you now have that premium. You know you can just deliver the stocks you own if it ends up getting called, and you've got a little bit of extra income to help cushion your downside.

Justice: So I've cushioned the downside, created some income, but in exchange I've given away a lot of the potential upside for stocks if there's a rally that ensues.

Kay: Exactly.

Justice: It's something if you're seeking a little bit of benefit today, a little bit of safety during periods when options are more highly valued than they were just a few months ago.

Kay: Exactly. If you imagine another March 2009, April 2009 coming along, this isn't really the strategy for you because you'll be capping off your returns. But on the other hand, if you think about it right now, a 10 percent rally, a 15 percent rally from today's levels, the point where that option will get called out, means actually going back to 1,200 on the S&P 500. It means going back to exactly where we were just a month or two ago when everything seemed fine.

Justice: Sure. OK. What about other options? I know that there are VIX products available in the ETF structure, and this is a way that you can dynamically hedge your portfolio. But when we say dynamic, you need to be watching that portfolio pretty closely, because it requires a lot of re-balancing.

Kay: Yes. Right now there is the VXX, which is the iPath Short-Term VIX S&P 500 Futures.

Justice: So you're not actually buying the VIX itself. You're buying futures contracts.

Kay: Exactly. You're actually buying the futures contracts that are one or two months out. The largest problem with this is that it tends not to bounce as much as volatility does.

Justice: OK, so if volatility goes up to 50, I should expect my futures probably to only go up to 45.

Kay: Yes, something along those lines. You can easily see, say, volatility tripling over a period when the short-term futures would only double in value or go up one-and-a-half times in value.

That is something which is not that great of a boon when you consider this should only be a very tiny part of any portfolio. It should only be, say, a five percent stake at the most, because of course the moment that volatility falls off, the flip side of that doubling is it can pretty easily halve as we saw in 2009.

Justice: You make a good point, when volatility falls off. We say that this is a mean-reverting investment. Over the longer term, it tends to stay at one stable level with very brief spikes. The funny thing about volatility measures is that they're even more volatile than the underlying market that they track.

So if you're going to have it in your portfolio, you need to make sure that when volatility picks up in the market, once you've already had the position established, that's the time you should be selling it, rather than buying it and reinvesting it in the other securities.

Kay: Absolutely. Over 2009, people were bidding up those futures prices because they were so concerned about a double dip. We're starting to see it now, but the reality was that it still declined about 60 to 70 percent during that period.

If you had tried to buy it at the beginning of 2009 to serve as your insurance and you had never added to that stake, you had never kept up with re-balancing it, you would right now still only be at, say, two-thirds of where you were, even after recent bounces in volatility.

Justice: Sure. It's always a good idea to buy homeowner's insurance before your house is on fire, and I think that if you're going to use VIX as portfolio insurance, it's better to do it when volatility is low knowing that you'll pay a premium for some time just to have safety in those moments of disaster.

Kay: Absolutely.

Justice: Thank you for those insights in volatility. For this and more ETF information, please visit the ETF Investor website or the Morningstar ETF Center on Morningstar.com.