The Chicago Board Options Exchange Market Volatility Index (known as VIX) measures the implied volatility of S&P 500 index options – one way of measuring the expected 30-day stock market volatility. This index has historically shown high daily correlations to the performance of the S&P and is therefore one of the tools used by managers seeking to hedge their equity exposure.
One interesting development in the second half of November was that the sharp (and brief) downturn in US equities had very little impact on the VIX. This is unusual and caused problems for some fund managers, for example in the absolute return sector, who were using VIX options in a bid to moderate the downside volatility of underlying equity exposure. As a result, we saw funds fall more sharply than they or investors would have expected over the very short period. And while markets subsequently retraced, the speed and unexpected nature of the downturn at the portfolio level led some managers to cut their exposure for risk reasons and consequently fail to participate in the subsequent rally in equities.
This indicates the potential risk with hedging strategies and the benefit of diversifying portfolio-level hedges across different instruments to help ensure that a portfolio reacts as close to expectations as possible to adverse events, thus mitigating the risk of unexpected volatility stopping out high-conviction positions. It is a truism that markets and associated instruments behave most unexpectedly, perhaps even irrationally, at the times of panic and therefore, by extension, that hedges cause surprises when they are most needed. This is similarly important in fixed income markets, where credit default swaps (CDS) are often used to hedge underlying cash bond exposures; their behaviour can, however, diverge significantly at extremes due in part to the different investor bases of the two markets.
By Anthony McDonald