Monday, September 24, 2012

Volatility Risk Premium

One of the more alluring investor myths is that you can get paid a premium for having the patience to withstand risk. It's like getting paid more for working at a smelly job rather than a job surrounded by wonderful smells: in equilibrium, the bad thing no one likes (risk, smells) are compensated via an extra return. You can formalize this and it forms one of the pillars of finance under the rubric of 'risk premiums'.

 Yet, as I point out in my book The Missing Risk Premium, to a first approximation the risk premium has a negative sign. Using Popperian logic, the profession should have moved along a long time ago, but it persists for several interesting reasons that I discuss in my book (eg, it's beautiful if true, it's a key fallacious assumption that underlies so many other threads, etc.).

Now there's PIMCO writing about how to capture the 'Volatility Risk Premium' by selling vol. They correctly note that on average, implied volatilities are a couple percentage points higher than actual volatilities, so 2% higher. Thus, it seems clear that writing options, collecting premium on 22% and paying on 20% generates a straightforward premium.

 Consider what may appear to be a great example of their argument: the VXX. it has lost 97.8% of its value since inception in January 2009, while the VIX has only declined by 66.8%. Win for risk-taking volatility sellers!

This phenomenal extra 8% annualized negative return drag (underperformance of VXX vs. VIX) comes from two sources.  One is the fact the VXX tries to match the daily return, and in sample that have negative autocorrelation, this strategy will underperform its benchmark over long periods.  This is best shown by this piece by Cheng and Madhavan at Barclays.  The other is the contango in this market, so that trying to maintain a fixed forward volatility position causes one to lose money riding down the VIX futures curve which has been very steeply sloped since the inception of this stupid product.  

That gets to the bottom line, which is that the premium of going short the VXX has little to do with risk--it's negative return is much bigger than any estimate of the equity risk premium--but rather technical issues within the contract.  You can try to capture this by trading yourself or becoming a short seller, but this highlights that to capture a return premium you need to actively educate yourself and put on positions that take at least a little work (eg, shorting the VXX is more complicated that simply going long the VXX), not passively invest in a fund that has 'risk' and does this all for you.  

If a fund purports to give you a risk premium for simply giving them money it's a classic sucker's pitch.  Consider that after 50 years there's no agreement on what the risk factor is: originally it was a beta with the broad market, now it's a covariance with something, though interestingly things correlated with well-known risk factors like 'size' or 'value' don't exist outside of the characteristic-based portfolios that actually create these factors.  That is, if you find a currency, or low book equity/market equity stock that has a high value loading, these assets don't generate higher-than-average returns as theory suggests they should. So, if you magically discovered the risk that underlies risk premiums, it would be in your best interest to keep it to yourself, not give it away to investors, and call it alpha, because no one would know. 

It simply isn't plausible people are finding risk premiums and giving this to passive investors, and naive investing is just what underlies all those fools going long the VXX in hopes of making money off Black Swans. While selling vol (shorting the VXX) is in a certain way selling Black Swans, the similarity is that some 30k foot metric like improbability is something you get paid for, whether you are buying or selling it.  You have to roll up your sleeve and earn it, taking out those pesky middle-men.  


John said...

You should think that people would be chomping at the bits for products that write variance swaps if the volatility premium were that huge.

Nick Dunbar said...

The VXX is a red herring. By going long a variance swap, you can make money from realized vol. For example, MetLife Inc. reported a $77m gain from variance swaps in Q2.

Eric Falkenstein said...

Nick: Vol has declined since Mar-09. On average, it doesn't.

I do think that yield or/volatility curves, when sloped, offer opportunities, but I wouldn't call in risk because I would do them when sloped up or down.

Anonymous said...

There is no bleeding due to negative autocorrelation in VXX because it has no leverage(or leverage is one). The effect you are talking about is for leveraged ETF's. XXV has that effect for example.

N N said...

Barclays put out a note combining selling vol on low realized vol stocks. You might find it interesting.

James said...

Is the contango in vix futures that kills VXX an artifact of the same tail risk protection premium or something else?