After years of stability, the return of volatility to global markets in February 2018 saw those not predicting it suffer substantial drawdowns. NN Investment Partners (NN IP) demonstrates the continued attraction of systematically selling volatility, regardless of the prevailing level of volatility, with expected returns exceeding losses over the long term.
Strengthening economic conditions and accommodative policies made last year the least volatile year in decades. The existence of the Volatility Risk Premium combined with the VIX ‘fear index’ dropping to a historic low, made the selling of volatility a rewarding strategy. However, in 2018 volatility returned with a vengeance.
On 5 February, expectations of higher inflation and the spectre of increased Federal Reserve rate hikes caused the VIX to undergo its largest move in history. The resulting fallout led to the closure of the XIV (an exchange traded note which was short volatility and shut down after triggering a termination event) and an equivalent ETF (SVXY) lost almost 90 percent of its value.
However, NN IP shows that investors can still profit from systematically selling volatility. Such a strategy relies on capturing the Volatility Risk Premium, which is the difference between implied volatility (priced into options) and subsequent realised volatility.
Buyers of implied volatility are willing to pay a premium as it enables them to transfer risk off their balance sheets, comparable to buying insurance while expecting, and often even hoping, it to generate a loss.
Stan Verhoeven, senior portfolio manager factor investing and solutions at NN Investment Partners said: “Selling volatility comes with significant short-term risks, however long term gains should sufficiently compensate for future tail-risk events. It is better therefore not to try timing the next tail-event, but rather take a long-term approach and manage the embedded risks by investing in a broader set of diversifying factors.”
NN Investment Partners is the asset manager of NN Group N.V., a publicly traded company listed on Euronext Amsterdam. NN Investment Partners is headquartered in The Hague, The Netherlands and manages approximately EUR 240 billion in assets for institutions and individual investors worldwide. NN Investment Partners employs over 1,100 staff and is active in 15 countries across Europe, US, Latin America, Asia and the Middle East.