Is the volatility risk premium starting to “break”? Some media reports would have you believe there are now too many sellers of volatility and that this is somehow eroding the value of the VRP
This topic is worth some additional thought, since investors often ponder whether a particular investment they hold has become too popular or crowded. While popularity in many instances is a good thing, in the realm of investing it can imply diminished future returns. Some contend that volatility selling has become too popular and thus returns going forward will be disappointing. However, the evidence of the VRP being too popular or crowded is decidedly mixed. And for the record, we don’t think the VRP is breaking, starting to break, or even dropping hints of breaking. But before exploring that further, let’s quickly review what the VRP is.
The volatility risk premium: A form of financial insurance
As we noted in a July blog post, the VRP is frequently compared to a financial insurance premium that volatility sellers collect from volatility buyers. There are a number of ways an investor can sell volatility, including via equity index options. In this scenario the option seller accepts what might appear on the surface to be an unfavorable payout profile while the buyer secures a very favorable payout profile that limits risk. In exchange the buyer must be willing to compensate the seller.
This is very similar to how insurance works for consumers. Insurers agree to pay auto policyholders in the event of, say, an accident, in exchange for the premiums those policyholders pay to the insurance company. This arrangement relies on those premiums being, in aggregate, enough for the insurance seller to cover an unfavorable payout scenario to the insurance buyer and realize a profit (or else why would they be in the insurance business?).
The incremental premium an option seller receives is identified through the implied volatility used to price index options. That implied volatility is consistently higher than the subsequent realized volatility of the underlying index, and this IV–RV spread is what option sellers seek to monetize when they harvest the VRP.
Does the VRP have too many sellers?
As option-selling strategies have grown in popularity in recent years, it’s natural to ask whether investors are killing the proverbial goose that laid the golden egg. The presumption here is that an abundance of volatility sellers has dramatically reduced or eliminated the VRP. Proponents of this view frequently advocate long volatility strategies as a form of risk reduction at low or no cost. Their analysis often includes some cherry-picked backtest period that reports poor performance from option selling or superior results from option buying. While the conclusions are interesting, when viewed a bit more objectively, they’re unconvincing.
To look at this subject a little closer, we used a public index, the MRA Volatility Risk Premium Index (MRAIVRP), that measures the spread between one-month at-the-money implied volatility and subsequent 20-day realized volatility. A positive IV–RV relationship provides support for the existence of the VRP. The chart below presents a 60-day moving average of the index to smooth results.
Source: Bloomberg, 10/23/19. Index data is provided for illustrative purposes. It is not possible to invest directly in an index. The index is produced by Macro Risk Advisors LLC (MRA). Please refer to the MRA website for index methodology. MRA makes no representation regarding the content of this material.
As you can see, the index spends a majority of its time above zero. However, there are a number of instances throughout the index’s history when it dwells in negative territory, including several in the past three years. What we don’t see, however, is a systematic shift to below zero in the index or even a material downward trend that would support the notion of “too many sellers.”
It’s important to remember that the VRP isn’t a fixed coupon that investors clip on a regular basis. It’s a risk premium. In fact, some have argued that it’s a close cousin to the credit and carry risk premiums. Similar to these other risk premiums, the VRP isn’t stationary. At different points in time it will be high or low, and we won’t know its actual level until after the fact. Financial theory tells us that the buyer of index options should pay the seller a premium for a favorable payout profile. What financial theory doesn’t tell us is what that premium should be at any point in time, and certainly not in advance.
Another way to think about the VRP is to look at the topic from a different perspective. If the VRP’s expected return were zero, risk-averse investors would be able to materially reduce the downside risk of their equity portfolios by buying some combination of index options for no expected cost. Could this happen? Sure. After all, who would have thought negative interest rates were possible? Is it sustainable over the long term? Unlikely. As we know from our own life experience, for insurance to be viable and sustainable it must come with a cost.
The bottom line
With apologies to Mark Twain, rumors of the VRP’s demise are greatly exaggerated. The equity VRP is a robust and well-researched risk premium, but it’s like any other risk premium—it will ebb and flow over time. Investors who approach it from this perspective will be best served in the long term.