Societe Generale is set to break into the increasingly crowded market of equity volatility products with the launch of an exchange-traded fund, which it claims provides the optimum balance between cost of carry and sensitivity to volatility by dynamically re-allocating between short- and medium-dated VIX futures.
In collaboration with the S&P 500 index, SG has created the S&P 500 VIX Futures Enhanced Roll Index, which will provide investors with exposure to equity volatility in a UCITS-compliant format. The index is due to list on NYSE Euronext on April 26 having received regulatory approval from the French regulator Autorite des Marches Financiers.
“We wanted to build something replicable, transparent and very liquid that would be the best possible hedge for equity volatility,” said David Escoffier, co-head of global equity flow at SG in London. “Other indices try to enhance your returns through strategies embedded in black boxes. This product does what it says on the box – it’s the best way to be long volatility in a liquid fashion.”
Like many other equity volatility products, the S&P VIX Enhanced replicates the performance of the Chicago Board Options Exchange Market Volatility Index – which measures the implied volatility of S&P 500 index options – and is widely acknowledged as the most effective hedge against equity market crashes.
VIX is not directly tradeable, so investors usually have to buy VIX futures in order to get exposure to volatility. But the contango of the VIX futures curve in benign markets means holding short-dated VIX futures incurs severe negative carry. In contrast, medium-dated VIX futures have less negative drag, but are nowhere near as reactive to volatility spikes, undermining their effectiveness as a hedge.
“Because of the contango of the curve, holding short-dated futures means you will bleed carry when the VIX is steady, and you’re only happy when you get a Lehman-type event, which is very rare. But investing in just medium-term futures, while less costly day-to-day, means you barely get a reaction to volatility spikes,” explained Stephane Mattatia, head of equity flow engineering at SG in Paris.
“When you buy long volatility exposure, by definition you don’t know when the spike is going to occur, so you have to stay in the product. We wanted to create a product that you can stay in without getting killed by the carry, while still benefiting from rises in volatility.”
The S&P VIX Enhanced looks to strike this balance by dynamically shifting between medium-dated and short-dated VIX futures depending on the movements of the VIX. In calm markets, the S&P VIX Enhanced is invested in medium-dated futures (the third, fourth and fifth future).When the VIX breaches an appropriate threshold (set at 135% of the VIX’s 15-day moving average, based on the VIX’s standard deviation), the index automatically reallocates in to short-dated VIX futures (the first and second future) to capture this move.
The re-allocation takes place over the course of five days to optimise liquidity and avoid sudden readjustments based on anomalous spikes. Once the VIX falls to its 15-day moving average again, the index switches back to medium-term futures to mitigate the costs of further declines in the VIX and being long volatility day-to-day.
“After Lehman, the VIX went up and down very quickly. Our product takes the benefit of all of the spike and then doesn’t suffer the collapse of the VIX on the way down,” said Mattatia. “It also does so in a manner which is transparent and liquid, which clients can easily trade in and out of.”
SG said the index had performed favourably in back-testing when compared to other equity volatility products, which tend to focus either only on short- or medium-dated futures. It also estimates a portfolio with an allocation of 90% in the S&P 500 and 10% in the S&P VIX Enhanced would have outperformed the S&P 500 by 18% since the end of 2006, and would have had a realised volatility of 20.6% versus 26.4% for the S&P 500 over the same period.
Christopher Whittall