Sunday Morning Coffee

Winters here are great (old picture). I really enjoy having a fire, splitting wood is great exercise and shoveling snow is not so bad when you don't have to do it in the dark trying to get to work.

To take a page from Adam Warner, the Striking Price column in Barron's had an interesting article about volatility as an asset class. This seems like a good follow on to Friday's post.

The article cited a paper by Maria Grant and Krag Gregory from Goldman Sachs. The conclusion of the paper is that enough return can be generated selling volatility that a substantial portion of a portfolio should be allocated to it. Again that is the conclusion from the paper not me.

One interesting observation made in the paper is "that big investors must buy options to hedge their positions." As I only have the article and not the actual paper I will say this statement is sort of strange.

Who is "big" and why can't "big" sell to hedge their positions too?

The paper also notes that "volatility selling tends to outperform long equities in hostile markets, offering diversification benefits." The authors also say "an asset class is defined by expectations that a passive position in it will produce significant returns above cash over time. Additional determinants include long-run returns that don't depend on investment skill, and diversification benefits in unfavorable markets."

I don't believe I have ever read that definition anywhere before and it is intriguing. There are volatility indexes aplenty besides the ones tied to the S&P 500. There would be some obstacles to implementing investment products tied to VIX and the like much as there were problems listing VIX options. The problems that I am aware of have to do with hedging the exposure of the various traders providing liquidity and I remember back when VIX was at 10 puts struck at 9 had no bid. There are also issues with VIX measuring 30 days making the utility of options further out than that questionable.

I don't know if the solution is a managed product that combines volatility of different indexes, a simplistic strategy like selling strangles (as suggested in the research paper) and puts against stocks or indexes not using a volatility index, an ETN that simply gives you the effect or something else.

Fortunately we don't need to be the ones to figure this out. A VIX-like product seems inevitable. It may take trial and error from one or two product providers before a good one comes--I can see a first attempt having an unintended consequence or two.

The topic is very interesting. Clearly there is nothing easy about gaming volatility but it is just as clear that volatility can be uncorrelated to moves in the stock market. Like with the Put Write Index, someone will write a white paper about how to navigate this market and then the products will come. Once the products come we can read the white paper watch the product trade for a bit and then decide whether it makes sense.

An advantage to an exchange traded product over the options is not having to manage expiration. Obviously there are people that are better off with options in this light but that is not the majority of investors.

Conceptually adding return independent of US stocks is appealing. There is no need to be the person who figures out how to deliver the product and there is no need to be the first one in.