Hedging with the VIX ETF: Effectiveness in Tail and Drawdown Reduction

Authors: Cheung, W.

Publisher: Nomura International plc., London


Volatility as an asset class has been widely considered as an equity portfolio hedging instrument owing to its negative correlation with the equity markets, which tends to be particularly strong in downside markets. Since its launch in June 2010, the S&P 500 VIX Source ETF (the “VIX ETF”) offers institutional investors a simple way of gaining volatility exposure. It is a liquid and flexible vehicle for hedging with minimal credit risk.

We examine the effectiveness of using the VIX ETF as a hedge instrument from the perspective of: • Return distribution revision; • Tail loss reduction; • Drawdown distress relief; and • The existence of a performance-enhancing hedging strategy.

When looking at reducing the tail losses, our Delta One Analytics team analysis suggests that in order to keep the weekly tail loss constant at 4%, an S&P 500 equity portfolio should have an allocation to the VIX ETF if volatility, as measured by the VIX index, is expected to stay or rally above 20. If the VIX index is expected to decrease or stay below 20, there is no need to allocate to the VIX ETF to keep the weekly tail loss below 4%. Our analysis also suggests that the reduction of the tail loss per unit held of the VIX ETF is convex with volatility. The higher the volatility, the more effective the VIX ETF is as a tail reduction hedge.

Source: Manual