Did you predict that the first half of 2017 would be a good time to harvest volatility risk premium?

we did.

Did you predict that February and December 2018 would be bad times to harvest volatility risk premium?

We did.


The Huygens active derivatives portfolios

Our active derivatives portfolios are designed to harvest “Volatility Risk Premium" (VRP), a well-known behavioral bias of stock market investors to overpay for insurance against investment losses.  We offer this strategy because VRP harvesting can be a source of investment gains with low correlation to stock and bond returns, therefore diversifying and enhancing your overall investment performance.

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Sometimes, the VRP can turn negative, typically in times when the economy is worsening or while stocks are selling off and stock market volatility is increasing. Because of this, our active derivatives portfolio generates returns by actively harvesting VRP. The portfolio is designed to:

  • Capture some of the volatility risk premium in low volatility or falling volatility periods, using a VRP harvesting portfolio designed to cushion minor volatility

  • Reduce risk in periods of higher volatility by switching to a bear market portfolio designed to protect assets against losses

  • Switch back to the bull market VRP harvesting portfolio quickly as the volatility abates


Volatility risk premium - a quick overview

Professional U.S. equity investment managers for institutions such as hedge funds, pension funds, and endowments use S&P 500 index put options widely as a type of insurance against stock market drawdowns, because they get more valuable as the S&P 500 index falls.

An index has been created (the VIX index) to track prices of these put options, and a family of futures contracts tied to it, to provide investors multiple ways to seek downside risk protection or to speculate on future volatility scenarios.

Because of the Volatility Risk Premium, S&P 500 put options and VIX future contracts predicting their value are generally overpriced.  As time passes and the futures contracts approach maturity, their prices generally decline as they converge with the value of the VIX index:

 

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To harvest VRP, our active derivatives strategy holds an ETF (ticker symbol ZIV) whose value reflects the returns of an index of short positions in mid-term VIX futures contracts. This is combined with the 10-year US treasury ETF (IEF) to cushion the portfolio against minor volatility:

If our system predicts the likelihood of excessive volatility is unacceptably high, the next day we move our client assets to a bear market portfolio of only the 10-year treasuries ETF, and wait for our system to indicate that conditions have turned more favorable:

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The above portfolio weights are for our customers that have selected moderate growth as their investment objective. The precise weighting of these ETFs in your portfolio will depend on whether you have selected the moderate growth or aggressive growth objective.

Our active derivatives strategy is the most aggressive strategy we offer, with accompanying risk of significant potential drawdown. For that reason it is not available to our customers seeking capital preservation as their objective.

 

Past 2+ years signal history - Huygens Active Derivative Portfolio Indicator

November 2016 through February 2019

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Past performance is not necessarily indicative of future results

In late 2016, Huygens introduced its Titan and Sidereal active derivatives strategies, designed for high net worth investors with aggressive growth or moderate growth objectives. The active derivatives portfolios we offer through our robo advisor are more conservative versions of these strategies, driven by the same active signal.

The above chart overlays the live signal history of the Huygens derivative market stress indicator on the daily price of the ZIV ETF, to give you a sense of how our signal is intended to protect against drawdowns when harvesting VRP.

 
 

Risks

The Huygens active derivatives portfolio is a highly risky and speculative investment strategy. Risks include the potential loss of the entirety of any investment in the derivative Exchange Traded Note (ETN) portion of the portfolio. The ETN that the portfolio employs to gain the desired exposure presents risks common to ETNs (including the risk that the ETN will not correlate with the index it seeks to track, which can occur for a number of reasons, and risks inherent in the volatility of the instruments in which the ETN invests). A single-day or intraday increase in the level of the ETN’s benchmark approaching 100% could result in the total loss or almost total loss of an investor’s investment in that ETN, even if such benchmark subsequently moves lower. We urge you to read the ZIV prospectus before investing in this strategy.