Chicago Board Options Exchange created the CBOE Volatility Index in 1933 but did not start trading the index until 2004. This index paved the way for volatility to evolve into an asset class. Here is how.

Diversification is the mantra of modern portfolio theory – one asset class goes up when another goes down. A portfolio diversified across multiple asset classes is less risky than one concentrated in one asset class.

The traditional low-correlation mix of stocks, bonds, commodities and alternatives did not hold during the Great Recession as virtually every market went down. The scope and speed of the crisis virtually eliminated low- or no-equity correlation opportunities. Now more institutions want and need volatility products to help address these market shocks.

The concept of volatility-as-asset got a toehold in financial markets with the 2007 research report from Goldman Sachs analysts Maria Grant, Krag Gregory and Jason Lui. The report stated that “equity index volatility-selling strategies have generated consistently high returns, with high Sharpe ratios, often substantially outperforming major equity indexes and hedge fund strategies, even at extremely modest levels of allocation.”

Volatility-selling strategies “have also tended to outperform long equity strategies in hostile markets,” the Goldman Sachs team wrote in introducing what many in the derivatives industry considered a ground-breaking report.

That research was augmented by Edward Szado, a research analyst at the Center for International Securities and Derivatives Markets (CISDM) at the University of Massachusetts, Amherst, who says selective volatility investments would have significantly protected portfolios during the S&P 500 Index’s late-2008 tumble.

“In times of market stress, correlations tend to significantly rise for many diverse asset classes,” Szado says. “However, one would expect volatility to significantly increase in times of distress, providing the diversification benefits missing from many other asset classes.”

Versatility with volatility investing is also a key feature, no matter the market conditions. “Covered option writing strategies have become increasingly popular in recent years as a means of return enhancement, and volatility products can be effective in hedging such strategies,” Szado says.

Missed opportunity?

The Goldman Sachs trio recognized at the time they issued their report that volatility-selling strategies had been underutilized by investors due to a lack of data beyond the Chicago Board Options Exchange’s CBOE Volatility Index (VIX), which is a barometer of stock market volatility and investor sentiment. With limited information on position-sizing strategies and scant focus on risk management in a portfolio context, the team created what it called a “risk-equivalent portfolio” model to help investors better strategize volatility plays.

For its part, CBOE rolled out the first exchange-traded futures contract on volatility with the VIX in March 2004. Two years later, CBOE launched VIX options. In less than five years the combined trading activity in VIX futures and options has grown to more than 100,000 contracts per day. Now, the scope for institutional investor diversification through volatility trades is widening.

In March 2010, CME Group and CBOE announced a seven-year licensing agreement to develop a series of volatility indexes expected to include crude oil, corn, soybeans and gold. That menu is likely to be expanded. CBOE will contribute the methodology behind its widely followed VIX. Prices used in the calculations will originate from CME Group’s actively traded options on futures contracts. CBOE will start publishing the indexes by third-quarter 2010 and CME Group will offer volatility contracts the following year.

The CME Group/CBOE deal marks the first time that CBOE will apply its VIX methodology to non-CBOE product data.

For the exchanges, the addition of volatility products that can be traded in liquid and transparent markets is a natural response to increasing demand from institutional investors, says Scot Warren, CME Group managing director of equity index products and services. Currently, some institutional investors are opting for over-the-counter variance swaps, agreements that generate payment based on the difference between initial volatility (variance) and subsequent realized volatility.

While these strategies “have no explicit delta exposure, they do tend to exhibit positive correlation to equity markets in times of distress,” says Eric Brandhorst, director of research in the global structured products group at State Street Global Advisors, in a research note.

Not one size fits all

While equity volatility tends to be negatively correlated with prices, this is not the case for all assets, CISDM’s Szado explains. Volatility in commodities, for example, is often positively correlated with their prices. Plus, volatility is generally considered to be mean-reverting and tends to cluster. Volatility distributions tend to be significantly skewed with a perceived lower-end limit and significant breakouts to the upside.

Certainly, investor education must rise in step with increased demand. “It is important that investors consider these characteristics when adding volatility products to their portfolios,” concludes Szado.