The Problem:
Yield is scarce and often comes with traditional asset class risks.
Our Solution:
Capture a Distinctive Yield Source
The Problem:
Yield is scarce and often comes with traditional asset class risks.
Our Solution:
Capture a Distinctive Yield Source
A Non-Traditional Yield Source – The Volatility Risk Premium
The Sagewood Volatility Yield Strategy pursues a source of yield that does not carry the credit or interest-rate risk of fixed income, the idiosyncratic risk of stocks, or the illiquidity of private assets.
This yield opportunity is found in the Volatility Risk Premium, which has been an enduring feature of the investing markets and has typically shown low correlation to stocks and bonds.
What is the Volatility Risk Premium?
The Volatility Risk Premium (VRP) is the spread between Forecast and Actual price volatility in the S&P 500 Index. The VRP has two components:
Forecast (or Implied) volatility:
A real-time measure of the 30-day forecast of S&P 500 Index price volatility. It is measured by the VIX and is derived from the prices of S&P 500 index options.
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Actual (or Realized) volatility:
The actual 30-day standard deviation of the S&P 500 index returns.
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VRP
Volatility Risk Premium
S&P 500 Implied Volatility Has Tended to Overshoot Realized Volatility
S&P 500 30-Day Implied vs. Realized Volatility
January 1986 – June 2020
Source: Bloomberg, CBOE. Data before 1990: S&P 100 and VXO Index. Data after 1990: S&P 500 and VIX Index. This change was made to reflect a migration in options trading volume away from S&P 100 index options and to S&P 500 index options. Inception date of chart corresponds to start of data availability on implied volatility.
Three observations emerge:
Over the past 35 years, forecast volatility has exceeded actual volatility 90% of the time suggesting that, over time, capturing the VRP has been a rewarding strategy.
While the magnitude has varied, the difference between implied and realized volatility — measured by the VRP, has averaged 4.11%.
Like any other risk premium, the VRP compresses during macro-economic expansions and expands during recessionary environments or periods of economic distress.
What is the Volatility Risk Premium?
The VRP is a manifestation of investors’ desire to reduce the uncertainty around future prices in the financial marketplace. Investors can limit outcomes or protect against certain outcomes using options. In this way, the option works like an insurance contract: the asset is a financial one and the protection is needed both on the upside and the downside.
Much like home or flood insurance, buyers are willing to pay a premium for that insurance. In times of stress or heightened uncertainty, they are willing to pay even more. The insurer assumes the risk and charges a premium as compensation for the asymmetry of outcomes it faces. The amount they would pay to a homeowner if a flood occurred is far greater than what they would collect in premiums from that homeowner.
Yield with Little Correlation to Traditional Asset Classes
In addition to offering yield potential over time, the VRP has typically shown relatively low correlation to traditional asset classes.
As a result, it can be a strategic complement to traditional asset classes in an overall portfolio context.
Traditional Asset Class Correlation with VRP
October 2007 – June 2020
|
Correlation with VRP |
|
| S&P 500 | 0.50 |
| Hedge Funds | 0.66 |
| Investment Grade Bonds | 0.02 |
| Commodities | 0.55 |
Source: Bloomberg – S&P 500 (SPX Index), Hedge Funds (HFRIFWI Index), Investment Grade Bonds (LBUSTRUU Index), Commodities (DJCI Index).
Investing in the VRP
It is not easy for investors to access the VRP in a transparent and liquid way. However, the team at Sagewood Asset Management has extensive experience using options to do just that with our Volatility Yield Strategy.
Have questions? Ready to talk?
Contact Sagewood at
[email protected] or (212) 231-8770
Want to learn more?
Meet the Sagewood Team
The team at Sagewood Asset Management offer a yield-oriented strategy in an overlay. Sagewood’s strategy aims to add yield to fixed income, equity, cash or diversified portfolios, without incurring the idiosyncratic risks of equities or fixed income.
