Intro

We are on a journey to better understand the elusive asset class of volatility, especially as the market volatility remains palpable.  There are lots of crazy chart patterns out there, and we highlighted a few fun ones in our recent piece “Charts &…CHARTS!”.  The chaos is visible.

We are taking on a herculean task of finding volatility solutions and fighting this market monster.  After all, we have insurance against our homes, our health, and our cars – why not try to insure our portfolios?  Many want the insurance – that is the good news.  The challenge – it’s not as easy (or cheap) as it looks.  Portfolio insurance was all the rage in 1987…until it backfired and was a major catalyst for the one-day 22% correction.

At C&P, one of our objectives is to attempt to simplify the complex world of volatility.  We will make generalizations, give analogies, and draw over-simplified conclusions to get a point across.  The data is out there, and people are good at spinning data and time-frames any which way to support their case.  We will talk in broader strokes to simplify.  At the risk of sounding trite, we will push the journey forward.  Now that we got our disclaimer out of the way, let’s dig in.

The 2022 Case Study

It’s often easiest to understand a concept when we look at the extremes.  Last year was challenging, as both stocks and bonds had big down turns.  The 60/40 portfolio logged one of it’s worst years on record.

Now let’s see how the asset class of volatility performed, as many portfolios and positions were shredded.  Here are the 2022 returns for the largest volatility exchange traded products:

VXX: down 24%

VIXY: down 25%

VIXM: unchanged

These are complex vehicles with some serious rocket-science math.  If you want to hear for yourself how complex this world is, you can listen to the trailer for the latest launch of the S&P 500 Futures Defined Volatility Indices here: https://www.spglobal.com/spdji/en/index-tv/article/a-dynamic-approach-to-volatility-management.

Yes, 2022 was an outlier year, and yes, we can come up with a pile of excuses as to what happened with each of these volatility funds. But the bottom line is – they did not offer the protection one would expect.  Maybe this year will be different.

We will give a shout-out to the VIX Index, which was up almost 26% in 2022, and we will address the VIX in a future post.  It is worth mentioning that there are many other volatility products fighting to stand-out amongst this elusive group, as there appears to be room for improved solutions.

Let’s Take a Step Back

It all starts with awareness.  What are we dealing with here?  We know the markets are risky, and we are trying to find some trades, products and ideas that offer some type of protection in a down market.  In order to better understand what is happening, we need to break this elephant down and take one small bite at a time.

A good place to start is to look at the relationship between the markets and the economy.  It makes sense that a strong economy would lift all boats.  If the economy is strong, then that should lead to a strong market.  That used to be the case, but this relationship has broken down.  The example we like to use is the hot-air balloon, with the balloon being the economy and the basket as the markets.

A growing economy used to lift the markets.  But with the financialization of the planet, the roles are reversed: the markets are now the balloon.  The markets need to keep being filled with hot air to keep the economy afloat.

Another favorite analogy is the tug-o-war between inflation and deflation.  In the 2008 GFC (Great Financial Crisis) the market wanted to deflate…and it did (prices were going down).  To offset this deflation, The Treasury implemented a massive inflationary jolt and a $700B TARP (Trouble Asset Relief Program).  Our over-simplified version is The Fed managed this balancing act between inflation and deflation over the years, and they did it beautifully for a long while.  The deflationary forces kept building with all the debts and deficits, as the inflationary QE (Quantitative Easing – AKA money printing, and more specifically and properly known as the creation of currency units) became all the rage globally.  Both complex systems of inflation and deflation kept growing, which also means that the risks also grew…exponentially.

We can now better understand how the relationship between the economy and the markets have broken down.  Whenever the markets turned south, there was apparently too much at stake and the “money printer” was turned on to make sure the markets (thus economy) did not fail.  We transitioned into a period where good news is bad news and vice versa.  A key question became, “How long can this game last?”  Some market specific questions became, “What are we hedging?  How are we hedging?  And why are we hedging?”

Hello Covid!  The Covid action was extreme and happened fast.  In a few short weeks the markets collapsed, and in order to save the deflationary day, the inflationary jolts were massive: rates to zero and QE-infinity.  It now appears this beautiful symmetry and balancing act has broken.

But We Still Need Hedges

We are left trying to solve the volatility puzzle with questions like, “What are we hedging and how?”  We still want volatility in our portfolios to hedge our downside exposure, right?  After all, we do think volatility is an asset class, right?

We must reference our friend and sharpest mind in the volatility business, Christopher Cole of Artemis.  We are huge CC fans and want to share a couple of our favorite CC charts and parts here.  A favorite quote:

There is a tiresome debate as to whether or not volatility is an asset class.  Let me end that debate: volatility is the ONLY asset class.

– Christopher Cole.

A favorite chart:

The above chart highlights the strong correlation between all asset classes and supports the need for hedges.  We think we are diversified by owning many different assets, but in periods of extreme market stress, the volatility monster destroys all.  Said another way, it is important to incorporate long volatility into your portfolio in some way, shape, or form.

The Journey Continues

Given those CC words of wisdom – how can’t we include volatility in our multi-asset model?  This is the journey we are on.  The fun part is that we see the volatility in the journey itself.  We now have chaos in the markets, wide discrepancies in the return data for volatility instruments, and a story line that is challenging to hold onto.  We will try our best to keep things simple and entertaining, with an eye towards solutions.

A PARTING THOUGHT AND A HINT

Here is the ChatGPT definition of volatility:

We can instantly see why this is a herculean task.  The definition of volatility is anything but brief and concise…and understandable.  Our simple hint – this is not a math problem.

Disclaimer: The information contained in this article is for informational purposes only and should not be considered as investment advice. The information presented in this article should not be interpreted as a recommendation to buy, sell or hold any security or investment. Before making any investment decisions, it is important to do your own research and seek advice from a qualified professional. Investing in securities and other financial instruments carries a high level of risk and may not be suitable for all investors.