There is a misconception about the volatility risk premium (VRP) amongst some investors which can lead them to under-allocate to the strategy. 
The assumption is that the VRP tends to correlate with equities at the wrong time, with investors consequently becoming concerned about the magnitude of losses should equity markets fall.
At Fulcrum, we believe this is not the whole picture and that, rather, the VRP can play an important role for investors as it can be valuable across market cycles as part of a wider investment portfolio, helping diversify a portfolio and reduce risk.
The VRP is defined as the difference between the implied volatility on an option and the volatility that is then subsequently realised on the underlying asset. The tendency for implied volatility to persist above realised volatility reflects a desire by investors to pay a premium for options in order to hedge their downside equity risk or to speculate to the upside. Accordingly, sellers of these options are compensated for bearing this risk: the volatility risk premium is, in all senses, a pure and identifiable alternative risk premium.
We have examined several data sets to reveal how the VRP would have performed under differing conditions. We look firstly at ‘type one’ events where implied volatility is already elevated, before then looking at ‘type two’ events where implied volatility is seriously out of alignment with the subsequent realised volatility.
‘Type one’
Using the S&P 500, we first looked at all negative quarterly excess returns since 1996. In total, the equity index has recorded 27 negative quarters over the period, or 30 per cent of the time. The below graph shows that an S&P 500 VRP strategy actually produced positive returns in 16 of those 27 quarters, averaging a 1.4 per cent quarterly return.
Source: Fulcrum Asset Management
A key feature is the robust performance during phases of positive equity excess returns alongside the largely uncorrelated returns on the downside.
A useful case study is the equity downturn that followed the bursting of the technology bubble of the early 2000s. This collapse was as dramatic for equity investors as the global financial crisis was in later years yet, as the chart below shows, a VRP strategy on the S&P 500 seldom dipped and instead weathered the initial collapse before continuing to accrue profits.
Source: Fulcrum Asset Management
The reason for this is explained by the underlying mechanics of VRP strategies. As implied volatility remained persistently higher than realised volatility, sellers of implied volatility were able to capture the premium. So, while put protection buyers would have enjoyed several short periods of positive returns, systematic put protection strategies are likely to have been an expensive luxury over the period, as markets failed to consistently fall far enough to justify the put premium.
It is this that best highlights the key to the volatility risk premium. At its core, the VRP is an insurance premium: the seller of insurance reaps more reward immediately after an event, whether that be a bump to one’s car, a flooded bathroom, or an event in the equity markets.
‘Type two’
‘Type two’ volatility events are nonetheless the primary source of concern for many investors. Since 1996, the defining volatility event was the global financial crisis when it would have been reasonable to expect an S&P 500 VRP strategy to have suffered throughout given the very sharp shift from low to extremely high volatility.
The chart below shows that as markets headed towards the Lehman default in September, the VRP strategy continued to accrue gains as the S&P 500 index started to head lower. The VRP then became engulfed by the accelerating crisis, losing value as realised volatility pushed up towards 80 per cent.
Source: Fulcrum Asset Management
At this point, the dynamics witnessed during a typical ‘type two’ volatility event assert themselves; implied volatility has now reset higher and there are plenty of ‘forced’ buyers of optionality keeping it elevated. The change in dynamics results in the stabilisation of the VRP strategy in November despite the equity market continuing to be in freefall. From this point on, the VRP strategy powers ahead, despite the equity market not bottoming out until early March 2009.
While the VRP can indeed protect over the course of an equity downturn, isolated extreme upside events, though rare, do occur. The last hoorah of the tech bubble in March 2000, when the S&P 500 index rose almost 10 per cent in a month, resulted in the VRP strategy losing money. Fortunately, however, these events can usually be managed through a strategy that benefits from international diversification across a range of global assets.
Diversification across assets is also, of itself, an important point. We have seen that a VRP strategy on an equity index profits, more often than not, during periods of severe equity weakness, but what happens if we extend the analysis to a multi-asset context?
To examine this, we combined gold, WTI (west Texas intermediate), sterling, Treasuries and the S&P 500 and re-ran the earlier quarterly analysis using the diversified VRP strategy as opposed to the single asset strategy.
The improvement was compelling, with positive returns now in 21 of the 27 negative S&P 500 quarters, up from 16, at an average of 1.6 per cent.
We have sought to address a misconception amongst some investors that the volatility risk premium “correlates at the wrong time”. Analysing the performance in all negative quarters of the S&P 500 since 1996 of both a VRP strategy focused solely on the S&P 500, and a more diversified VRP strategy implemented across five assets, we observe strong outperformance and the ability of the VRP to be additive to portfolios over time.
Most importantly, it is the dynamics of the VRP strategy that underpins these results. Profit arises from a desire by market participants to purchase options at a premium in order to protect on the down-side or speculate to the upside. In periods of equity stress, these mechanics are amplified, enabling option sellers to sell at increasingly profitable premiums. It holds true across asset classes.
Phil Strother is head of systematic research at Fulcrum Asset Management. The views expressed above are his own and should not be taken as investment advice.