Our Titan and Sidereal strategies generate returns by tactically harvesting the equity Volatility Risk Premium (“VRP”). The VRP, in simple terms, is a measure of the extra price investors are willing to pay for protection against equity market losses, as compared to the price a rational investor with perfect information would pay. The difference is positive most of the time – in other words, investors are generally willing to overpay for insurance against losses. Our system is designed to capture this premium only during times when the probability of an abnormal equity market drawdown is low. If our system determines the likelihood of an equity drawdown is unacceptably high, we move our client assets to cash the next day and wait for our system to indicate that conditions have turned more favorable.
To harvest the VRP, both strategies will hold a short position in VIX futures contracts (or an ETF containing these contracts). These contracts are typically priced above the current (or "spot") level of the VIX index, with the difference reflecting, in part, the VRP.As time passes and the contracts approach maturity, their price must converge with the spot VIX index.If forecasted volatility does not appear, the futures contracts prices will fall to meet the spot level, and our clients will benefit.
The above chart illustrates this process for the August 2016 futures contract. As of July 20, 2016, the spot VIX Index was priced at 11.8 and the August 2016-expiry VIX Futures contract was priced at 15.5. This price difference reflects, in part, the VRP investors were willing to pay for equity drawdown protection in the summer of 2016. The chart shows the declining price of this contract each week, as equity market volatility failed to materialize. Eventually on August 17, the contract matured at a price equal to the spot VIX index at the time. Investors who shorted this futures contract on July 20 earned 2.7 points (from 15.5 to 12.8), or 17%, in the 21-day period from July 20 to August 17.
Of course, the performance of this approach will vary over time. The summer 2016 data, while better than the average month, are not uncommon. Bull and sideways equity markets generally present opportunities to harvest VRP, as do the recovery phases of bear markets. Attempting to harvest VRP should be avoided during the onset of an equity correction or bear market. The discernment of better or worse conditions for VRP harvesting is the core of Huygens’s tactical system that drives our strategies.
We designed our system in 2016, after spending two years reviewing academic research and experimenting with live trades. We studied 11 years of daily market data and examined our system’s hypothetical responses to it. Over this time frame, in hypothetical tests our system recommended having exposure to the VRP-harvesting position 45% of trading days, and remaining in cash 55% of days.
Our Titan strategy is the purest expression of this approach; the Sidereal strategy combines it in a portfolio with a long position in 10-year treasuries, trading some potential absolute return for potentially more stable portfolio returns.