January 10, 2019

Volatility – An Investable Asset Class

Ever since the onset of the financial crisis in 2008, volatility has become a critical aspect for investors to consider in their portfolios. The slump in asset prices and the jump in the price of options offering downside protection reflected what is a fundamental variable in investment returns.

Volatility – a measure of the level of uncertainty in financial markets – has also become a unique and versatile asset class for investors seeking to diversify and hedge their portfolios, as well as to increase returns via directional views and arbitrage strategies. There is now an extensive menu of possibilities for both institutional and retail portfolios to invest in volatility.

In an exhaustive review of STOXX’s equity volatility offerings and beyond, a new research paper1 by Anand Venkataraman, Head of Product Management at STOXX, dissects their objectives, construction methodology, performance, and accessibility through passive investments.

Venkataraman starts his review of volatility as an investable asset class by introducing equity volatility, both implied and realized, and its most defining features. These include its uneven performance, highly inverse correlation to share prices, and mean-reverting profile. The paper then goes on to review ways to isolate and invest in volatility.

Volatility indices

The best-known volatility instruments are indices tracking the implied volatility of options on equity benchmarks. These reflect the market’s expectations of near- to long-term volatility. In Europe, the most widely-followed examples are the EURO STOXX 50 Volatility (VSTOXX) Indices, which measure implied volatilities of EURO STOXX® 50 Index options across their entire expiration curve. The VDAX-New® Index tracks options prices on Germany’s DAX®.

These indices offer exposure to pure volatility – i.e. the portfolio does not react to price fluctuations but only to changes in volatility.

The EURO STOXX 50® Volatility of Volatility Index (V-VSTOXX) measures the implied volatility of options on VSTOXX futures, hence reflecting expectations regarding the volatility of volatility.

Volatility strategy indices

An extensive list is made up by STOXX’s volatility strategy indices. These includes the EURO STOXX 50® Investable Volatility Index, which measures forward implied volatility in the Eurozone equity market, the VSTOXX® Short-Term Futures and VSTOXX® Mid-Term Futures Indices, VSTOXX® Short-Term Futures Investable Index and VSTOXX® Short-Term Futures Inverse Investable Index.

The family is completed by the Dynamic VSTOXX® Index, which combines the VSTOXX Short-Term Futures Index and the VSTOXX Mid-Term Futures Index to exploit the superior performance of short-term futures when the volatility forward curve is in backwardation and of mid-term futures when the volatility forward curve is in contango. The EURO STOXX 50® Volatility-Balanced Index combines investments in the EURO STOXX 50 and in the VSTOXX Short-Term Futures Index.

Each index covers a specific volatility strategy in a systematic and accessible way and allows investors to target their desired view, term and structure on volatility.

Option-buying and -writing strategies

STOXX also offers indices tracking popular option-writing strategies. These include the EURO STOXX 50® BuyWrite Indices and the DAXplus® Covered Call Index, which recreate the strategy of holding a long position in an underlying while selling a call option on it. The EURO STOXX 50® PutWrite Index replicates a collateralized strategy of writing put options on the EURO STOXX 50 Index on a monthly basis.

On the side of option-buying strategies, the EURO STOXX 50® Protective Put 80% 18m 6/3 Index and the DAXplus® Protective Put Index replicate strategies of holding an underlying and a put for hedging purposes.

Finally, the EURO iSTOXX® 50 Collar Index is an example of a strategy combining two types of options. A collar is constructed by owning shares of a security while simultaneously buying puts and selling calls on it.

Possibilities beyond our indices

The possibilities to invest in volatility do not end there. Investors can also resort to other strategies, Venkataraman writes, such as options straddle, short strangle, and volatility arbitrage with variance swaps. Although not currently available as STOXX indices, many of these strategies may well be implemented as a STOXX index should there be interest, using the building blocks already utilized for the existing indices.

Volatility has exceptional fundamentals and characteristics that should be well studied by any investor seeking to exploit it, most noticeably that up moves in volatility tend to be sharp and unpredictable. Those fundamentals have raised volatility’s appeal, while a growing list of products have transformed it into an investable asset class.

Featured indices

1Venkataraman, A., ‘Volatility – An Investable Asset Class,’ STOXX, January 2019.