Condor Options

Volatility is the only asset class that makes sense for hedging an equity portfolio, since it protects against the actual thing that investors are worried about. Fixed income, commodities, gold, etc. all have their neat quirks, but their value as portfolio hedges is orthogonal, at best. Investors love smooth, positive returns most of all and love sharp, jagged declines the least. Long volatility strategies like VXH produce outsized gains during those sharp, jagged periods of high volatility, making them the best possible approach to hedging. To borrow from a memorable medieval superlative, getting long volatility is a hedging strategy than which nothing greater can be conceived.

I introduced the VIX Portfolio Hedging (VXH) Strategy in 2010 because I wasn’t satisfied with anything anyone else was offering. I had clients and newsletter subscribers constantly asking about ways to hedge their tail risk without incurring massive costs, and none of the products or strategies I could find met those needs. The VXH strategy is not conceptually complex – it takes long positions in volatility products like VIX futures or VXX shares, and varies the level of exposure as dictated by the market. By taking small hedge positions most of the time and dialing up our exposure as stocks become more volatile, we are able to capture the lion’s share of any volatility explosion (and the profits associated with it) while avoiding excessive costs during normal market environments.

While the backtested performance was excellent, we now have some live results worth talking about. I think two charts and one table should tell the story well enough. VXH returns are calculated using managed client account performance, and so are net of commissions and fees; SPX and VXX returns are hypothetical, and so do not include those costs. That means actual performance is slightly better than shown here.

1. The Benefits of Tactical Allocation shows live VXH performance compared to the performance of the VXX ETN. From late December 2010 to August 26, 2011, VXH returned 60%, versus a return of just 11% for VXX over the same period. The huge gains in during this August market selloff are the most attention-getting, but I also want you to note the relative outperformance of VXH during January and February: you can see that the black line (VXH) steadily hovers above the green line (VXX). I am convinced that the greatest risk to investors is their own psychology – so keeping costs low and keeping performance as smooth as possible is crucial to prevent us from talking ourselves out of portfolio protection.

2. Using VXH to Hedge a Stock Portfolio shows the returns of a portfolio tracking the S&P 500 versus the same portfolio employing VXH as a risk management overlay. The unhedged S&P 500 portfolio is down about 5% on the year, while the hedged portfolio is actually profitable.

James Montier of GMO wrote an “ode to the joy of cash” earlier this year, claiming to show how a fixed allocation to cash provided a better portfolio hedge than making a similar fixed allocation to VXX. Well, yes. But that’s a rather fantastic straw man argument, since I have never met anyone claiming that a fixed VXX allocation is a good idea. The whole premise of the VXH strategy is that, instead of dumping our hedging capital into VXX (or cash, or …) all at once, applying some modest allocation rules will get us protection that is not only more effective than hoarding cash, but is cheaper, too.

3. How much does VXH cost? There are plenty of ways to gain long volatility exposure and avoid severe market declines. What should be clear by now is that the only viable hedging strategies are the ones that don’t impose severe costs during normal market environments. The table below displays the monthly cost of the VXH strategy, shown as the difference in percentage returns between the hedged and unhedged portfolios. The VXH cash allocation in operation here is about 8% of the value of the portfolio, i.e. $8,000 is devoted to VXH to hedge a $100,000 account, with actual positions in VIX futures varying in nominal size from 1% to 30% or more of the value of the core portfolio (where long volatility positions are concerned, we can cheer for margin).

For instance, in March 2011, our unhedged S&P 500 tracking portfolio returned 1.97%, versus a return of 0.88% for the portfolio hedged with VXH. That was the most expensive month in the period. As of August 26, the August unhedged return was -7.73%, with a gain of 0.84% for the VXH-hedged portfolio. Again, a stock portfolio hedged with VXH has beaten the market by nearly 5% this year.

There are two ways to access the VXH Strategy: by subscription, or in an individually managed account.