The Cboe Volatility Index® (herein “VIX®” or “VIX® Index”) has become something of a household name. Known sometimes as the “Fear Gauge”, the VIX tracks market participants’ expectations for future S&P 500 Index volatility. In other words, the VIX provides information about the prospect for fluctuations (up or down) in equity markets. When the VIX is high, market volatility is expected to be (or is currently) high. Notably, market volatility is generally higher when equity markets are declining versus appreciating, thus the “Fear Gauge” moniker.
As a result, the VIX typically skyrockets during times of market stress or selloffs. The past decade has seen several events where the VIX has ripped higher, including the 2008 Financial Crisis, the 2018 “Volmageddon”, and 2020’s pandemic related scare.
Most Investors are Naturally Short Volatility
Most people’s portfolios implicitly and statically bet against volatility by being mostly composed of equities and bonds. This is generally appropriately: the VIX has an unconditional expectation of a negative return; that is, on average, being statically long volatility will lose money over time. Being short volatility is the general approach that most professionally managed long only equity mutual funds and ETFs make, as U.S. equity markets generally have a positive expected return and negative correlation to the VIX. Indeed, a long position in front month VIX futures during 2020 would have lost money over the course of the entire year, despite trebling in March from pandemic related turmoil in financial markets.
This chart represents the return of the rolling front month future contract for the Cboe Volatility Index. Returns are rebased to 1 with a start date of 1/1/20.
Therefore, we believe a successful approach to trading both equity markets and volatility must have exposure to equity market most of the time, and selective exposure to the VIX when it counts. Some funds achieve this through static option contracts, accepting capped upside for some downside protection. We believe that being occasionally long volatility (long VIX futures) can be a useful hedge against market turmoil, with the VIX Index increasing more on average than the S&P 500 Index declines during large selloffs (see chart 1)
In summary, we believe an intelligent approach to trading volatility derivatives can help a portfolio limit volatility and potentially produce positive (or less negative) returns during periods when equities are under pressure.
Astor’s Approach to Trading Volatility
Substantial internal research at Astor has resulted in a sub strategy within Astor’s Macro Alternative Fund that seeks positive exposure to volatility during times of market stress. The goal of the strategy is to hedge away positive beta (to the S&P 500), or equity exposure, during short windows where volatility is expected to rise. We believe the strategy is robust, systematic, and repeatable. There are various inputs (both fundamental and technical) that determine when a hedge is placed and how much of the overall beta is hedged. The strategy also makes use of novel machine learning techniques. For reference, at one point in 2020, the strategy indicated that 100% of the fund’s positive beta should be hedged. In the second half of 2020, however, the hedge was rarely ‘on’ and no more than 40% of the fund’s beta was hedged at any point.
The chart shown represents the target percentage of the Fund’s calculated portfolio beta that was hedged through futures contracts held within the Subsidiary. Portfolio beta is calculated based on the cash and ETF holdings within the Fund. The inception of the Fund is 6/22/15. No hedge strategy positions were held prior to July 15, 2019. The chart is not a representation of performance achieved by the Fund.
In sum, we believe access to long volatility strategies (or exposure to volatility hedges) may provide value to an investor’s portfolio. Although many ETFs or mutual funds make use of static option contracts to protect against downside risk, we believe our intermittent hedging strategy provides a valuable differentiated approach.
Important Risk Information
Mutual funds involve risk including the possible loss of principal. Past results are no guarantee of future results and no representation is made that a client will or is likely to achieve positive returns, avoid losses, or experience returns similar to those shown or experienced in the past. All information contained herein is for informational purposes only.
The Fund seeks to achieve its objectives by investing primarily in Exchange-Traded Funds (“ETFs”). An ETF is a type of Investment Company which attempts to achieve a return similar to a set benchmark or index. The value of an ETF is dependent on the value of the underlying assets held. ETFs are subject to investment advisory and other expenses which results in a layering of fees for clients. As a result, your cost of investing in the fund will be higher than the cost of investing directly in ETFs and may be higher than other mutual funds with similar investment objectives. ETFs may trade for less than their net asset value. Although ETFs are exchanged traded, a lack of demand can prevent daily pricing and liquidity from being available.
The Fund can purchase ETFs with exposure to equities, fixed income, commodities, currencies, developed/emerging international markets, real estate, and specific sectors. The underlying investments of these ETFs will have different risks. Equity prices can fluctuate for a variety of reasons including market sentiment and economic conditions. The prices of small and mid-cap companies tend to be more volatile than those of larger, more established companies. It is important to note that bond prices move inversely with interest rates and fixed income ETFs can experience negative performance in a period of rising interest rates. High yield bonds are subject to higher risk of principal loss due to an increased chance of default. Commodity ETFs generally gain exposure through the use of futures which can have a substantial risk of loss due to leverage. Currencies can fluctuate with changing monetary policies, economic conditions, and other factors. International markets have risks due to currency valuations and political or economic events. Emerging markets typically have more risk than developed markets. Real estate investments can experience losses due to lower property prices, changes in interest rates, economic conditions, and other factors. Investments in specific sectors can experience greater levels of volatility than broad-based investments due to their narrower focus. The Fund can also purchase unleveraged, inverse fixed income and equity ETFs.
The Fund may execute portions of its investment strategy (e.g. commodities exposure), by investing up to 25% of its total assets (measured at the time of purchase) in a wholly-owned and controlled Subsidiary. The Subsidiary will invest primarily in futures contracts for assets such as commodities, currencies and fixed income securities. However, the Fund may also make these investments outside of the Subsidiary. The Subsidiary is subject to the same investment restrictions as the Fund, when viewed on a consolidated basis. By investing in futures contracts indirectly through the Subsidiary, the Fund will obtain exposure to financial markets such as commodities within the federal tax requirements that apply to the Fund.
The Fund may directly or indirectly invest in derivatives (including stock index, fixed income, currency and commodity futures or swaps) to enhance returns or hedge against market declines. The Fund’s use of derivative instruments involves risks different from, or possibly greater than, the risks associated with investing directly in securities and other traditional investments. These risks include (i) the risk that the issuer to a derivative transaction may not fulfill its contractual obligations; (ii) risk of mispricing or improper valuation; and (iii) the risk that changes in the value of the derivative may not correlate perfectly with the underlying asset, rate or index. Derivative prices are highly volatile and may fluctuate substantially during a short period of time. Such prices are influenced by numerous factors that affect the markets, including, but not limited to: changing supply and demand relationships; government programs and policies; national and international political and economic events, changes in interest rates, inflation and deflation and changes in supply and demand relationships. Trading derivative instruments involves risks different from, or possibly greater than, the risks associated with investing directly in securities. Derivative contracts ordinarily have leverage inherent in their terms. The low margin deposits normally required in trading derivatives, including futures contracts, permit a high degree of leverage. Accordingly, a relatively small price movement may result in an immediate and substantial loss to the Fund.
An investor should consider the Astor funds’ investment objectives, risks, charges, and expenses carefully before investing. This and other information about the Astor funds are contained in the funds’ prospectus, which can be obtained by calling 877.738.0333. Please read the prospectus carefully before investing. The funds are distributed by Northern Lights Distributors, LLC a FINRA/SIPC member. Astor Investment Management is not affiliated with Northern Lights Distributors, LLC. This is not a solicitation to offer investment advice or services in any state where to do so would be unlawful.
Astor Investment Management LLC (“Astor”) is a registered investment adviser with the Securities and Exchange Commission. This is not a solicitation to offer investment advice or services in any state where to do so would be unlawful. Analysis and research are provided for informational purposes only, not for trading or investing purposes. All opinions expressed are as of the date of publication and subject to change. They are not intended as investment recommendations. These materials contain general information and have not been tailored for any specific recipient. Astor and its affiliates are not liable for the accuracy, usefulness, or availability of any such information or liable for any trading or investing based on such information. There is no assurance that Astor’s investment programs will produce profitable returns or that any account will have similar results. You may lose money. Past results are no guarantee of future results and no representation is made that a client will or is likely to achieve results that are similar to those shown. Any particular client may experience results different from other clients. Factors impacting client returns, results, and allocations include account inception, money transfers, client-imposed restrictions, strategy and product selection, fees and expenses, and broker/dealer selection, as well as other factors. An investment cannot be made directly into an index. Please refer to Astor’s Form ADV Part 2A Brochure for additional information regarding fees, risks, and services.
Cboe Volatility Index (VIX®): The Cboe Volatility Index is calculated from the price of S&P 500 Index options and is designed to provide information on investors’ 30-day future expectations of volatility.
Correlation: A statistic that measures the degree to which two securities move in relation to each other.
Standard & Poor’s 500 Total Return Index: The S&P 500 Index measures the performance of 500 large cap stocks, which together represent approximately 80% of the total equities market in the United States. The total return calculation includes the price-plus-gross cash dividend return. The S&P 500 is registered trademark of McGraw Hill Financial.
Volatility: A measure of the degree of movement of the price of an investment/instrument.