Using a volatility-hedge to improve asset allocation performance

In 2018, Sébastien Page, CFA, and Robert A. Panariello, CFA, from T. Rowe Price published their paper, “When Diversification Fails.”

The Following three quotes sum-up their findings.

One of the most vexing problems in investment management is that diversification seems to disappear when investors need it the most. Of course, the statement that “all correlations go to 1 in a crisis” is both an oversimplification and an exaggeration. But it has been well documented that correlations tend to increase in down markets, especially during crashes (i.e., “left-tail events).

Diversification fails across styles, sizes, geographies, and alternative assets. Essentially, all the return seeking building blocks that asset allocators typically use for portfolio construction are affected.

Finally, investors should look beyond diversification to manage portfolio risk. Tail-risk hedging (with equity put options or proxies), risk factors that embed short positions or defensive momentum strategies, and dynamic risk-based strategies all provide better left-tail protection than traditional diversification. The strategy of managed volatility is a particularly effective and low-cost approach to overcome the failure of diversification.


The CBOE Volatility Index, or “VIX,” is an indicator of expected S&P 500® changes derived from current traded prices of S&P 500 options.

VIX, also known as Wall Street’s “fear gauge,” is closely watched by a wide range of market participants, and its levels and patterns have become part of the standard vocabulary of market commentary.

Although the VIX is not explicitly tradable, an investor may gain exposure to anticipated volatility by purchasing VIX futures and options. VIX futures were first listed on an exchange in 2004, followed by VIX options in 2006.

The price of a basket of tradable constituents—specifically, a basket of options that expire in the next month or so—determines the amount of VIX, as it does other indices.

The profit or loss that option buyers and sellers make over the life of the options will be determined, among other things, by how much the real volatility of the S&P 500 varies from the volatility “implied” by VIX at the beginning of the contract.

During the 2000–09 decade, equities endured two deep bear markets, with several short-term stretches of high investor volatility.

Most investors remember how global equities correlations soared, making conventional diversification targets difficult to achieve.

VIX futures and VIX options saw massive growth during the crisis, as interest in and use of index-based products like exchange-traded notes and exchange-traded funds increased.

These products are now commonly used in investors’ strategies, ranging from trading tactical volatility views to integrating volatility trades and hedges into risk management and multiasset strategies.

Tail risk, which can cause significant losses in portfolios during steep stock market declines, is of particular concern to fund managers.

The S&P 500 VIX Mid-Term Futures Index

The S&P 500 VIX Mid-Term Futures Index is a tradable index that measures the return on a long position in mid-term VIX futures.

The fourth, fifth, sixth, and seventh VIX futures contract months are all months where long positions are kept.

It replicates a hypothetical VIX futures portfolio that holds the fourth-, fifth-, sixth-, and seventh-month VIX futures.

As the time to expiration of the futures gets shorter, the location in the fourth month is continuously rolled over to the seventh month, retaining a 5-month maturity.

The VIX futures curve is usually in contango, which means that short-term futures contracts are usually cheaper than long-term futures contracts.

As a result of roll costs (or, to borrow a word from commodity markets, “negative roll yield”), the S&P 500 VIX Mid-Term Futures Index has continued to fall over time.

The S&P 500 VIX Mid-Term Futures Index is a common benchmark for various long volatility strategies.

Elliott Wave Oscillator (EWO)

The EWO is the ideal technical indicator for the S&P VIX Mid-Term since it is simply the difference between a five-period and thirty-five-period simple moving average.

The EWO indicator is used to determine where an Elliott wave ends and another begins. When the oscillator begins to put in a series of lower highs while price puts in higher highs a trend change is occurring.

The basis of the Elliott principle, which quantifies market crowd behavior, works best in equities that (1) have lots of volume (liquidity) and (2) move according to key forces of fear and greed on the part of many participants.

What about performance?

We find a cumulative asset growth advantage of 29% vs. a 100% S&P 500 VIX Mid-Term Futures Index from March 15, 2018 through May 7, 2021.

Asset Allocation

When we test a 10% allocation of the S&P 500 Mid-Term Futures Index to a strategic 90% stocks allocation and a dynamic allocation to the volatility hedge here are the results.

Here are the testing results: