Improving Hedge Fund Risk Exposures by Hedging Equity Market Volatility, or How the VIX Ate My Kurtosis

Abstract

In 2004 investors began trading futures on the volatility index (VIX). Investors can directly trade the volatility implied in stock index options. Because the VIX has a negative correlation to the S&P 500 and most hedge fund styles, we find that adding a small VIX position to an investment portfolio significantly reduced portfolio volatility. This strategy may be more effective at improving the robustness of Sharpe ratios than other methods explored in the literature. Even more important, VIX rises quickly during the most risky market conditions, which dramatically improves the skewness and kurtosis characteristics of many hedge fund strategies.

TOPICS: Options, futures and forward contracts, volatility measures