Tue, Sep 7, 2010 | Jared Woodard
Since the 2008 financial crisis, I’ve been contacted regularly by clients and readers who are looking for effective and cost-efficient methods for hedging their portfolios. The more time I’ve spent researching the topic, the more I’ve become convinced that most widely-known methods are ineffective as hedges, inefficient from a cost standpoint, or both. After nearly a year of research, I have developed an alternative method that can provide meaningful protection against sudden and/or large market declines while not imposing excessive costs under ordinary market conditions.
The VIX Portfolio Hedging (VXH) Strategy is designed to offer protection to equity investors against large price declines and market volatility by investing in products linked to the CBOE Volatility Index (VIX). The idea of hedging portfolios using long volatility positions is not new; what is new about this strategy is that it allocates hedging capital by gradually varying the level of exposure as the prevailing market and volatility environments change. Simply put, the strategy dials back hedging exposure when it isn’t needed (without ever becoming entirely inactive), and increases the size of volatility positions when things become more tumultuous.
In the coming days and weeks, I plan to lay out my case for the VXH strategy in the following series of posts:
- Conventional Hedging Methods Are Too Expensive – including both the offerings from banks and other big players and the methods favored by active individual investors.
- Novel Hedging Methods and the Crash Next Time – hedging strategies that require someone to be correct about some particular macroeconomic thesis strike me as silly or scary.
- A Cheaper Way: VXH in a Crisis-Free World – gaining long volatility exposure is easy, but keeping costs down is hard. How would VXH have fared if 2008 had never happened?
- The Discreet Charm of the VXX ETN – I’m on record as being violently opposed to anyone buying and holding VXX, so why did I build a strategy around it?
- VXH Performance in Detail – all the stats, tables, and equity curves you’re probably wishing I had posted instead of this promissory list.
My goals are to highlight the advantages of this strategy over its peers and to explain every novel or confusing aspect of it, so I’ll thank in advance anyone who submits questions or demands for clarification. For some of my previous discussion of tail risk hedging, see: 1, 2, 3.