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ETF. Among the worldwide indexes measuring implied volatility are the CBOE Volatility Index (VIX, now based on S&P 500 options), the CBOE S&P 100 Volatility Index (VXO, based on S&P 100 options), the India VIX Index and the FTSE 100 Volatility Index. These indexes can be very useful, as they are designed to be real-time measures of investor sentiment, and they can provide a general indication of how costly it might be to insure a portfolio with protective index put options. For example, if one takes the VIX Index and divides by 10, one can get an approximation of the percentage number of the underlying that an investor would need to put up as premium to hedge with one-month, at-the-money S&P 500 Index options. So for example, if the VIX were at 20 and an investor desired to hedge a $1 million portfolio with one-month, at-the-money S&P 500 Index options, the investor probably would need to post a premium of about $20,000 (which is 2 percent of the $1 million portfolio). With a price history dating from 1990, the VIX Index reached its all-time intraday high of 89.53 on Oct. 24, 2008. Prior to 2008, the highest VIX level was 49.53, on Oct. 8, 1998. The VIX Index closed at a record 80.86 on Nov. 20, 2008. The VIX Index closed above 50 on 50 trading days in 2008. Peak daily closing values reached by some other key implied volatility indexes in 2008 include the following—CBOE Crude Oil Volatility Index (OVX) 100.42 on Dec. 11; CBOE Russell 2000 Volatility Index (RVX) 87.62 on Nov. 20; India VIX Index (INVIX) 85.13 on Nov. 17; CBOE Nasdaq-100 Volatility Index (VXN) 80.64 on Nov. 20; FTSE 100 Volatility Index (VFTSE) 78.69 on Oct. 16; CBOE DJIA Volatility Index (VXD) 74.60 on Nov. 20; CBOE Gold Volatility Index (GVZ) 64.53 on Oct. 10; and CBOE EuroCurrency Volatility Index (EVZ) 30.66 on Oct. 31 (see Figure 6). Several Key Indexes Suffered Big Losses In The 17-Month Time Period From Late 2007 To Early 2009 Investment portfolios can endure huge losses in times of rising correlations, higher volatility and declining index values. As shown in Figures 7, 8 and 9, numerous indexes experienced big double-digit declines in the 17-month period from late 2007 through early 2009. Six key stock indexes (S&P 500, Russell 1000, Russell 2000, MSCI World, MSCI EAFE and MSCI Emerging Markets) all declined by more than 55 percent, and the S&P GSCI Index rose in early 2008 but then fell dramatically in late 2008, as there was concern about less worldwide demand for oil and other commodities with the worsening of the financial crisis. Many alternatives indexes also did not fare well over the 17-month time period shown in Figure 9; two major hedge fund indexes were down 17 percent or more, and the S&P/Case-Shiller index of home values in 20 markets declined 26.9 percent. In the year 2008, the S&P Listed Private Equity Index (TR U.S. $) was down 64.1 percent, the Cambridge Associates U.S. Private Equity Index was down 24.2 percent and the Cambridge Associates Venture Capital Index declined 16.5 percent. Questions About Diversification And Modern Portfolio Theory In light of the issues raised above, concerning higher correlations, higher volatility and lower returns, some investors have questioned whether the widely accepted principles of diversification and modern portfolio theory (MPT) continue to be effective. In the 1950s, Harry Markowitz introduced MPT with an emphasis on diversification of a portfolio and assumptions that investors are rational, markets are efficient and financial returns follow a normal distribution. Markowitz recently wrote that in 2008, “The S&P 500 fell approximately 38.5%; the higher-beta emerging-markets asset class fell much farther. Corporate bonds fell in value, but much less than equities, and government bonds went up. Small stocks went down, but not as much as might have been expected, given their historical betas. On average, they had a lucky idiosyncratic term during that interval of time. Generally, asset classes moved roughly in proportion to their historical betas. …the future is always uncertain, particularly in times of market volatility. When we make our best estimates for the next spin of the wheel, we must choose an appropriate point on the efficient frontier, the risk-return trade-off curve. Depending on our risk aversion, we may select a more cautious portfolio, loaded with lower beta securities or asset classes, or we may choose a point higher on the frontier, with higher yield but with higher beta securities or asset classes. …” 1 Figure 5 30-Day Historic Volatility For US Stock Indexes (DJIA from 1900 to 1927 and S&P 500 from 1928 to Sept 2009) End-of-Week Values 100 80 60 40 20 0 Jan ’00 Jan ’20 Sources: Bloomberg and CBOE Figure 6 Daily Closing Values 160 120 80 40 0 Jan 2 ’86 96.5 on 11/29/1929 Jan ’40 Mean 15.8 Median 13.2 Jan ’60 87.5 on 11/20/1987 Jan ’80 Indexes Measuring 30-Day Implied Volatility (Jan. 2, 1986-Nov. 2, 2009) 150.19 VXO on 10/19/1987 Jan 10 ’91 Jan 18 ’96 Sources: Bloomberg and CBOE Jan 30 ’01 100.42 OVX on 12/11/2008 80.86 VIX on 11/20/2008 Feb 21 ’06 80.9 on 11/14/2008 Jan ’00 OVX CBOE Crude Oil Volatility Index VIX - CBOE Volatility Index VXO - CBOE S&P 100 Volatility Index (pre-1990) www.journalofindexes.com January/February 2010 13
Diversification And Risk Management In 2008 While no one can predict the future with 100 percent accuracy, we can look at the asset performance in 2008 to try to gain a better idea of which assets might be good diversifiers and risk management tools in the event of future severe market crises. Markowitz noted that government bonds did well in 2008, Figure 7 5 4 3 2 1 0 Oct 9 ’07 Three Indexes Over 17-Month Time Period (Rescaled to 1 on 10/9/07 through 3/9/09) March 31 ’08 Sources: Bloomberg and CBOE Figure 8 -34.8% -47.7% -50.4% -55.3% -55.4% -57.4% -58.5% -59.5% -60.3% Sept 16 ’08 March 6 ’09 224% -48% -55% S&P 500 VIX Short-Term Futures Index S&P GSCI S&P 500 % Change In Total Return Indexes Over 17 Months (Oct. 9, 2007-March 3, 2009) Sources: Bloomberg and CBOE Figure 9 -17.0% -19.3% -25.8% -26.9% -78.8% 188.4% 157.5% 26.9% 18.3% 9.1% PUT - CBOE S&P 500 PutWrite Index S&P GSCI Nasdaq-100 S&P 500 Russell 1000 MSCI World Index Net US$ Russell 2000 MSCI EAFE MSCI Emerging Mkts % Change In Indexes Over 17 Months (Oct. 2007-Feb. 2009) S&P 500 VIX Sh-Term Futures Index VIX - CBOE Volatility Index Citigroup 30-yr Treasury Barclays CTA Citigroup Br Inv Grade Index Credit Suisse Tremont Hedge Fund CISDM Hedge Fund Equal-Wtd Mkt Citi High-Yield Market S&P/Case-Shiller 20 Mkts S&P Private Equity and indeed the Citigroup 30-Year Treasury Index was up 26.9 percent in the 17-month time period from October 2007 through February 2009. In the year 2008, these fixed-income funds all experienced gains: iShares Barclays Aggregate Bond ETF (NYSE Arca: AGG) up 7.9 percent, Vanguard Total Bond Market Index (VBMFX) up 5.1 percent, Pimco Total Return Institutional fund (PTTRX) up 4.8 percent and Fidelity US Bond Index fund (FBIDX) up 3.8 percent. The iShares Barclays TIPS Bond ETF (NYSE Arca: TIP) declined slightly (down 0.5 percent) (source: Bloomberg). In the Oct. 29, 2009, BusinessWeek in “Are Investors Ready for Higher Interest Rates?” Ben Steverman noted, “… the yield on 10-year U.S. Treasuries rose 0.08 points to 3.5 percent. That’s still a historically low rate, reflecting the fact that the Federal Reserve is holding the short-term federal funds rate near zero in order to stimulate the economy. It’s the reason why yields on bank savings and money market accounts are so paltry. Such low rates aren’t sustainable for long periods of time out of fear, among other things, that low rates can overheat the economy, spark inflation, or drastically devalue the U.S. dollar.” A big rise in interest rates over the next few years could put a huge dent in the performance of Treasury bonds. While Markowitz focused primarily on traditional investments such as stocks and bonds, many investors now are looking at alternative investments for diversification and risk management purposes. The SPDR Gold Trust (NYSE Arca: GLD) was up 4.9 percent in 2008, and up around 29 percent in 2009 through mid-November (source: Bloomberg). Investors now use options strategies such as protective puts, collars, and buy-write and put-write strategies to lessen portfolio risk. Over the 23-year time period from mid-1986 through mid-2009, the CBOE S&P 500 PutWrite Index (PUT) had lower volatility and slightly higher returns than the S&P 500 Index. In the 17-month time period shown in Figure 8, the PUT Index did decline by 34.8 percent, but still outperformed the S&P 500 by more than 20 percentage points. Some investors now are exploring the possibility of using assets that perform well in high-volatility markets to lower their overall portfolio volatility. While some key hedge fund indexes fell in 2008, many managed futures programs directed by commodity trading advisers (CTAs) performed relatively well in times of high volatility and big price swings, as the Barclay CTA Index rose 18.3 percent in the 17-month period shown in Figure 9. Over the past decade, many investors have expressed an interest in tradable products based on the CBOE Volatility Index, and in recent years, the following products were introduced—VIX futures in 2004, VIX options in 2006 and two iPath ETNs on VIX futures in 2009. The iPath ETN (NYSE Arca: VXX) is based on the performance of the S&P 500 VIX Short-term Futures Index, which was up 224 percent in the 17-month time period shown in Figure 7. A paper in The Journal of Alternative Investments showed that if an investor started with a typical portfolio and then added a 10 percent allocation to VIX futures over the time period from March 2006 through December 2008, the portfolio’s annualized Sources: Bloomberg and CBOE continued on page 62 14 January/February 2010
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Page 3 and 4: Contributors Rob Arnott Rob Arnott
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