Forum. Protection Strategies: Thinking beyond the VIX. A meeting place for views and ideas. Thomas Gillespie PhD, Director, Investment Risk Advisory

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A meeting place for views and ideas

Forum

Protection Strategies:

Thinking beyond the VIX

Published September 2012

Authored by:

Thomas Gillespie

PhD, Director, Investment Risk Advisory

Scott Maidel

CFA CAIA FRM, Senior Portfolio Manager, Equity Derivatives

Adam van Ness

CAIA, Head of Implementation, Australia and New Zealand

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Protection Strategies: Thinking

beyond the VIX

Prior to recent weeks, the widely followed VIX Index had only

rarely fallen below 15 in the last five years. This Forum is to

help investors better understand what the VIX is telling us at

this time, some protection strategies that make sense given

current markets, and, importantly, how Russell can help to

implement them.

WHAT IS THE MARkET TEllING uS?

Now might be the time to think about implementing protection strategies. In the last weeks we have seen the VIX dip and stay below 15, which takes us back to the exhilarating days of 2002-2007. We have not seen these levels, but for a few days, over the last five years, and the level is telling us the market is pricing risk in the low range of expectations (see Figure 1). This has been confirmed with other market indicators such as credit spreads and the level of the AUD/USD – a classic risk asset.

Source: Russell Investments 18 September 2012. For illustrative purposes only. Prior to 1990 the CBOE OEX Implied Volatility (VXO) has been used. Between 1990 and September 2003 the original VIX has been used as the methodology was changed at that time.

This bullish sentiment is at odds with the macro risks in the market (potential Europe breakup, China slow down and inflation fears, on-again-off-again US recovery, US indebtedness, to name a few). And then there are the contributing factors to support much stronger equity markets – cheap equity markets, particularly in Australia, and extremely low bond yields.

“Derivative practitioners

spend a lot of time talking

about volatility, skew,

smile, gamma...The most

important issue is the

price of the option bought

or sold and the protection

gained or upside given up.”

Jan 1986Jan 1988 Jan 1990 Jan 1992 Jan 1994Jan 1996 Jan 1998 Jan 2000 Jan 2002 Jan 2004 Jan 2006 Jan 2008 Jan 2010 Jan 2012

0 20 40 60 80 100 120 140 160

Current level VIX<15 Black Monday

VIX = 150

US Recession

VIX = 35 Bond Market Sell off-VIX = 20 Asian Market Risk VIX = 37 LTCM VIX = 45 Tech Bubble VIX = 34 S&P US debt downgrade & Euro Debt Crisis VIX = 48 9/11 aftermath VIX = 43 Iraq War VIX = 45 Subprime Credit Crisis & Lehman Failure VIX = 80 Soverign Debt Crisis VIX = 40 Average VIX=21 Stable Rising Equity Markets VIX≈10 Figure 1: VIX through market cycles

1 The VIX is a volatility index of short-term US equity (S&P 500 index) implied volatility derived from traded prices for exchange listed options and published by the Chicago Board Options Exchange. The VIX is a widely followed measure of investor uncertainty and is actively traded through exchange traded futures and options. Standard & Poor’s Corporation is the owner of the trademarks (S&P 500 and S&P/ASX 200), service marks, and copyrights related to its indexes. Indexes are unmanaged and cannot be invested

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DERIVATIVES: DEMySTIFIED AND

DE-jARGoNED!

Given the typical Australian Balanced/Growth style defined contribution superannuation plan with 50%-70% growth assets derives 80-90% of its total investment risk from equity factors, let us concentrate on equity protection strategies. The simplest derivative protection strategy is to buy a put – and let us keep it simple by considering index put strategies which are the cheapest way to hedge a portfolio and generally the most liquid. An index put option at the pre-determined expiry date is valuable if the underlying index is below the fixed strike price and theoretically directly compensates for the loss of holding index exposure. Figure 2 shows a typical pay off diagram of the overlay strategy of buying a put against existing physical holdings. Derivative markets spend a lot of time talking about historic volatility, implied volatility, skew, smile, term structure, delta, gamma ... But the most important issue for end users is the price of the option bought or sold and the amount of protection gained or upside given up – this is exactly what is shown on a payoff diagram – where the derivative strategy wins and losses. A straight forward cost benefit exercise without a mathematical formula in sight! - 40% - 30% - 20% - 10% 0% +10% +20% +30% +40% 3000 4000 5000 6000 Investment Return Level of S&P/ASX 200 Index Physical equity equity exposure Collar protected exposure

-40% -30% -20% -10% 0% +10% +20% +30% +40% 3000 4000 5000 6000 Investment Return Level of S&P/ASX 200 Index Physical equity equity exposure Put spread collar protected exposure

-40% -30% -20% -10% 0% +10% +20% +30% +40% 3000 3500 4000 4500 5000 5500 6000

Investment Return Level of S&P/ASX 200 Index

Physical equity equity exposure Put protected exposure Put option strategy outperfroms physical only strategy as put options have positive value at expiry if index is below strike (4050 in this example) Put option strategy underperfroms

physical only strategy as put options are worthless at expiry if index is below strike (4050 in this example) and premium is paid upfront

Figure 2: Put option payoff

Source: Russell Investments. For illustrative purposes only.

As an aside, there are a couple of things to note:

A) When looking to protect equity positions, it generally makes sense to buy longer dated options rather than shorter dated.

B) The converse is true – when extracting greater yield, it is usual to sell shorter dated options and roll frequently. C) As not all stocks in a market are perfectly correlated,

index options are generally cheaper than a basket of stock options – and a whole lot easier implement!

D) Each individual investors’ portfolio is different and objectives/risks are different – an “off the peg” unmanaged solution probably will not be the best solution in terms of cost and effectiveness.

With the VIX trading at 15 and lower there are a variety of choices for hedging. But firstly the VIX is a measure of price for the short dated S&P500 options traded on the Chicago Board Options Exchange. It does not tell us where the longer term options are priced and does not tell us about option prices in other markets.

PuT AND PuT SPREAD BASED STRATEGIES

Equity index put based strategies are appealing for a number of reasons: they are simple, the upfront and final cost is known, they are a direct hedge, they don’t rely on historic relationships holding in the period of a crisis, and are some of the most liquid derivatives in the market. Put strategies do have an element of tracking error for active portfolios that do not perfectly track the underlying index – but the upside is that any alpha generated by active managers is preserved . Indirect hedges such as VIX futures, volatility derivatives and dynamic asset allocation have merits but the appeal of put based hedges is they are direct, the cost is know upfront and they do not rely on historic relationships for the protection. What the VIX does not tell us is the cost of put protection – the price will vary with the time to expiry, the strike price, and from market to market. Figure 3 shows the cost of 1 year, 90% puts over S&P/ASX 200 (Australia) and S&P500 (US) over time. This data shows, despite the recent declines in option prices, the cost of protection is not inconsequential. A number of strategies of mixing both bought puts and sold put and/or calls can give rise to a cheaper protection strategy, but are usually conditional rather than absolute protection. With such collar strategies the upside is capped in exchange for typically zero upfront cost. The payoff diagrams for a couple of strategies are shown in Figure 4 – the collar strategy and the put spread collar. The relative pricing of these strategies vs. the standard put strategy also varies over time, and is typically driven by supply and demand. In the current market, put spreads and put spread collars are preferred over both outright puts and collars due to the relatively lower cost or funding the upfront cost by selling some upside potential.

2For an explanation of some of these terms and derivative market jargon please see Rae D. & Maidel S., “Equity Volatility and Implications for Option Strategies”, Russell Investments Research Report, May 2012, and Collie B., “Basic Greeks: Essential knowledge for investors considering options”, Russell Investments Research Report, April 2009.

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Jan 199 0 Jan 199 2 Jan 199 4 Jan 199 6 Jan 199 8 Jan 200 0 Jan 200 2 Jan 200 4 Jan 200 6 Jan 200 8 Jan 201 0 Jan 201 2 0 10 20 30 40 50 60 70 80 90 0% 2% 4% 6% 8% 10% 12% 14% 16%

Cost of 1 year 90% Total Return

Put

VIX Index

Put Price: S&P/ASX 200 Put Price: S&P 500 VIX Index

Investment Return

Figure 3: Historic Put Pricing

Source: Russell Investments 18 September 2012. For illustrative purposes only.

Source: Russell Investments. For illustrative purposes only.

Figure 4: other option Strategies

- 40% - 30% - 20% - 10% 0% +10% +20% +30% +40% 3000 4000 5000 6000 Investment Return Level of S&P/ASX 200 Index

Physical equity equity exposure Collar protected exposure

-40% -30% -20% -10% 0% +10% +20% +30% +40% 3000 4000 5000 6000 Investment Return Level of S&P/ASX 200 Index

Physical equity equity exposure Put spread collar protected exposure -40% -30% -20% -10% 0% +10% +20% +30% +40% 3000 3500 4000 4500 5000 5500 6000

Investment Return Level of S&P/ASX 200 Index

Physical equity equity exposure Put protected exposure Put option strategy outperfroms physical only

strategy as put options have positive value at expiry if index is below strike (4050 in this example) Put option strategy underperfroms

physical only strategy as put options are worthless at expiry if index is below strike (4050 in this example) and premium is paid upfront

- 40% - 30% - 20% - 10% 0% +10% +20% +30% +40% 3000 4000 5000 6000 Investment Return Level of S&P/ASX 200 Index

Physical equity equity exposure Collar protected exposure

-40% -30% -20% -10% 0% +10% +20% +30% +40% 3000 4000 5000 6000 Investment Return Level of S&P/ASX 200 Index

Physical equity equity exposure Put spread collar protected exposure -40% -30% -20% -10% 0% +10% +20% +30% +40% 3000 3500 4000 4500 5000 5500 6000

Investment Return Level of S&P/ASX 200 Index

Physical equity equity exposure Put protected exposure Put option strategy outperfroms physical only

strategy as put options have positive value at expiry if index is below strike (4050 in this example) Put option strategy underperfroms

physical only strategy as put options are worthless at expiry if index is below strike (4050 in this example) and premium is paid upfront

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4

VIX FuTuRES oR VIX BASED DERIVATIVES

In the last 10 years we have seen the rise of VIX futures and options, volatility based exchange traded funds (ETFs) and complex structured products. Many investors now use these tools for protection strategies. But these are not without their issues when considered as physical equity protection strategies.

» Roll cost: The VIX is not investible and so protection buyers are exposed to roll cost for futures. In most market environments, short dated VIX futures trade at a price less than the further dated futures (known as a contango market) – this implies VIX futures are expensive to roll. Consequently, since the iPath S&P 500 VIX Exchange Traded Notes (ETN’s) were listed in January 2009, the short-term contract has lost 95% of its value (total return basis, ticker VXX, based on 1 month VIX futures rolls). » Effectiveness lost by rolling longer dated futures: One strategy

investors and structured product providers use to avoid this roll cost is to roll longer dated VIX futures. But this has only reduced the roll cost, and longer dated VIX futures respond less quickly than shorter dated VIX futures and the VIX index itself. For example mid-term the iPath S&P 500 VIX ETN contract has lost only 60% of its value since January 2009 (total return basis, ticker VXZ, based on 5 month VIX futures rolls). In broad terms, the short dated VIX ETN is half as responsive to equity moves as the VIX index itself and the longer dated ETN is half as responsive again – in essence rolling longer dated futures still has a positive roll cost and it is far less effective as a hedge. » Not a direct hedge: For hedging equity risk, VIX strategies

rely on historically observed correlations persisting in periods of crisis when the protection is most required. Analysis has shown the relationship between equities and the VIX to be highly variable and fundamentally broke down in the period 2007-2009 when needed most. Moreover the popularity of VIX futures and options since 2010 has raised questions about the capacity of the market to accommodate rolling of positions and the potential unwinding of positions in periods of crisis to capitalise on the generally higher VIX levels.

EFFECTIVE STRuCTuRING AND

IMPlEMENTATIoN IS CRuCIAl

Effective structuring and implementation of any of these strategies is crucial to their success. Structuring the protection strategy is usually the first step, and starts with a careful consideration of the portfolio and investment objectives (risk objectives as well as the more common return objectives), investment horizon, risk budget, maximum loss tolerance and so forth. Crucial to the question of sizing of hedge positions is a full understanding of the risks: How well do the assets hedge the liabilities/objectives? How much diversification is there within the assets? How much equity beta is there in the alternatives portfolio?

Secondly, implementation is another key issue. Derivatives trade on and off exchange and it is important to understand the availability and liquidity of these alternatives both before the hedge is entered into but also under various market conditions to include the possibility of early termination or rolling of positions. For options traded off exchange, specialised documentation is required and competitive tenders must be held to ensure the best pricing is achieved. Moreover, if put options are bought off exchange then potential counterparty risk is a very real issue – especially for protection strategies because as equity indices decline, the puts become valuable, but also credit worthiness of typical counterparties weakens considerably. Counterparty vetting and diversification, as well as actively reducing counterparty risk with a daily margining process are essential.

RuSSEll’S STRuCTuRING AND

IMPlEMENTATIoN EXPERTISE

Russell has the expertise and ability to structure and implement protection strategies. Russell’s risk advisory service is well placed to analyse fund holdings and liabilities/ objectives, and to work with clients to structure the hedging strategy that meets client needs and satisfies the client’s unique set of constraints. Russell’s implementation services are also uniquely placed to act as fiduciary for clients to implement protection strategies with transparent cost, and an unconflicted ability to execute at the best price attainable and with only a client’s best interest in mind. Russell has a strong local and global presence to offer clients the best service locally based on the best global thinking.

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This document is issued by Russell Investment Management Limited ABN 53 068 338 974, AFS License 247185 (RIM). It provides general information for wholesale investors only and has not prepared having regard to your objectives, financial situation or needs. Before making an investment decision, you need to consider whether this information is appropriate to your objectives, financial situation or needs. This information has been compiled from sources considered to be reliable, but is not guaranteed. Past performance is not a reliable indicator of future performance.

Sydney 02 9229 5111

Melbourne 03 9270 8111

Website

www.russell.com.au

Address

Level 29 135 King Street Sydney NSW 2000 tgillespie@russell.com

Adam van Ness

Head of Implementation Australia and New Zealand Russell Investments

+61 2 9229 5557 avanness@russell.com

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