On February 5, 2018, the Dow Jones Industrial Average (DJIA) marked a new record declining by its largest point drop ever in one day, just six trading days after notching an all‐time high. By February 8, the index closed down more than 10%, into official correction territory. In response, many products offering exposure to short volatility crashed.
Unfortunately, few investors knew about our relatively new, short‐volatility mutual fund that, by design, was prepared for a catastrophic surge in volatility: The kind of surge that is capable of generating losses approaching 100%. The Fund is designed to respect that while the probability of such a dramatic volatility spike was slight, the mere possibility of such a surge demands respect. From day one, the Fund has been managed with the understanding that “possibilities,” no matter how remote, must be planned for.
On the day when that remote possibility became a reality and many short volatility strategies were literally “caught short,” the Measured Risk Strategy Fund was up 6%. This wasn’t due to the Fund manager’s tactical skill, but was planned for in advance and printed right in the Fund’s prospectus. The plan was in place then and, by prospectus, it will remain in place at all times.
There are many theories about why volatility skyrocketed that day. Market worries about inflation and rising bond yields may have contributed, resulting in a spike in volatility. Those betting against volatility had to cover their losses quickly, in after‐hours trading, which fueled higher volatility. Many blame the spiral on sophisticated trading programs that were prompted to sell with the dramatic swings in momentum, forcing more and more participants to cover short positions.
Regardless of the cause of the market’s decline, the short volatility trade blew up. A few products that used short volatility exposure were even forced to liquidate.
But not the Measured Risk Strategy Fund. For the full year 2017, the Fund returned 21.86%, and on February 6, against the backdrop of catastrophic losses in the short volatility space in 2018, it gained over 6%. Despite this, 2018 proved to be a very difficult year for short volatility and the fund eventually ended down 27.43% in 2018. Why would anyone invest in such a volatile investment vehicle? Consider, for example, that in 2008 the MSCI Emerging Markets asset class lost 53.33% of its value. The very next year, MSCI Emerging Markets delivered a 78% return. Rewards are often accompanied by high levels of risk. Investors in short volatility expect a high reward—as they received in 2017— but that reward often comes with downside risk.
What is short volatility?
Short, or inverse, volatility products typically generate positive returns when volatility, measured by what’s known as the VIX, is low or declining. The VIX is a measure of the expectation of implied volatility of the S&P 500 over the next 30 days. Historically, volatility readings decrease when the market is not moving much in either direction or trending up slowly, and increases when the market is falling or moving up and down rapidly. Investors in short volatility are rewarded when markets remain relatively calm. Short volatility products profit from the difference between the price of volatility currently vs. volatility one month into the future. Traders buy and sell options contracts on the VIX in order to be long or short (inverse) on volatility. For example, in 2017 the S&P 500 Short Term Futures Index, (with the ungainly symbol of SPVXSPIT) returned over 186%, benefiting from the low volatility environment during that time. During the same year, the S&P 500 gained about 22%. These huge gains lured some investors into a space they didn’t truly understand. When volatility surged last February and one‐month futures contracts rose more than 100 percent overnight, the short volatility trade was pummeled and investors who were attempting to profit from low market volatility were forced to close out their positions at a severe loss.
That surge in volatility in early 2018 resulted in short volatility products suffering huge losses as the SPVXSPIT ended the year down a staggering 97% with much of that happening on a single day. You can read more about what is now referred to as “Volmageddon” in the sidebar.
Traditional short volatility products took a painful, even fatal hit.
Even though all of the short volatility products that crashed on the February 5, 2018 volatility spike came with warnings of severe losses in their prospectuses, many investors were not prepared for losses of this magnitude. While short volatility as an asset class, as measured by SPVXSPIT, has delivered returns that have significantly outperformed the S&P 500 in three of the five years since its inception in 2012, it is also often subject to declines of more than 20% that can happen in just a matter of days or even overnight. Every day, the asset class is at risk of a complete meltdown, as we saw in February 2018.
Since the February crash in short volatility, many broker dealers are no longer allowing their advisors to invest in short volatility products. Others are no longer allowing investors to leverage their exposure to these products, requiring them to pay all in cash rather than on margin. Some of the products have subsequently re‐engineered their exposure to attempt to limit the extreme loss potential.
Is there a different alternative?
Short volatility products are not for those with weak stomachs, and generally are not recommended for retail investors. Advisors and their clients alike need to understand the risks involved, and not invest more than they are prepared to lose in a short period of time.
Measured Risk Strategy Fund is not a direct investment in short volatility, and as a result, does not carry the same catastrophic risk associated with being directly short. The Fund typically invests a limited percentage (up to 20% by prospectus, but typically much less than 10%) in options on volatility‐linked ETFs that seek to capitalize on flat or declining levels of volatility. Options are unique investment tools that seek to provide a level of certainty, which is not possible with conventional investments. That’s because options have contractual features that provide a formulaic payment based on the performance of a reference financial asset, known as the underlying asset. The payment for options is dependent on the performance of the reference underlying asset being above or below a predetermined price (strike price) on a specific date in the future (exercise date). The contractual nature of options makes them similar to personal property insurance contracts, as they make a payment on a future date that is contingent on an event taking place.
With these options in place, the remaining majority (80% or more) of the Fund is invested in US Treasuries with maturities typically less than one year. The benefit of this approach is that in the event of a large spike in volatility, especially over a short period of time, losses will be severe or even up to 100% in the core option holdings, but should be muted in the Treasury holdings which make up the majority of the strategy.
In addition to mitigating risk by limiting the investment allocation into options and the balance in more stable Treasury investments, the Fund also purchases deep out‐of‐the‐money options that are designed to payoff only in the event of a severe volatility spike. While these out‐of‐the‐money options have no intrinsic value while the market is stable, they hold the potential for significant profit if the market takes a drastic turn. Despite this structure, a rapid increase in the VIX over shorter periods of time could still cause the Fund to incur significant losses.
We started the Fund in 2016 to launch investment strategies that did not yet exist for our retail RIA clients. The Fund is small, with about $8.7m in assets, but it didn’t get that way by losing 90% of its value as others have. In fact, while we all know that past performance is not indicative of future results and there is no guarantee any investment will achieve its objectives, the Fund survived its first trial by fire during the market’s 2018 short volatility blowout. How? By acknowledging the possibility that previously unheard‐of volatility spikes could materialize without warning and planning accordingly… an inevitability that some other fund managers did not adequately respect.
(Source for returns: Bloomberg)
Important Information and Risks Associated with the Fund:
The Fund employs various strategies to achieve the objective of capital appreciation and income. The primary tool to achieve this objective is the use of derivatives, primarily options.
Options involve risk and are not suitable for all investors. The use of options and the resulting high portfolio turnover may expose the Fund to additional risks that it would not be subject to if it invested directly in the securities underlying those options. The Fund may experience losses that exceed those experienced by funds that do not use derivatives, options and hedging strategies. Purchased put or call options may expire worthless and may not deliver the expected return due to time value decay. Written call and put options may limit the Fund’s participation in gains and may amplify losses in market declines. The Fund’s losses are potentially large in a written put or call transaction, but will always be paired with an offsetting position or related option to prevent unlimited losses. The Fund is non‐diversified and as a result, changes in the value of a single security may have a significant effect on the Fund’s value. Despite the use of options as a primary strategy, a rapid rise in the VIX over a short period of time could still deliver significant losses to the Fund.
Other risks include U.S. Government securities risks and investments in fixed income securities. A rise in interest rates can typically cause a decline in the value of fixed income securities or derivatives owned by the Fund.
VIX: The CBOE VIX (S&P 500 Volatility Index) is a measure of market expectations of near‐term volatility conveyed by S&P 500 stock index option prices. The VIX is forward looking and seeks to predict the variability of future market movements. This is in contrast to realized (or actual) volatility which measures the variability of historical (or known) prices.
Volatility Exchange Traded Products (ETPs) may have significantly greater daily movements that that of the broad US equity markets. Investors cannot directly invest in an index and unmanaged index returns do not reflect any fees, expenses or sales charges. ETPs are subject to investment advisory and other expenses, which will be indirectly paid by the Fund. As a result, the 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 that invest directly in stocks.
Short VIX: A “short VIX” investment is one that is designed to correlate negatively or move opposite of the Chicago Board Option Exchange Volatility Index (VIX). These investments may take many forms but are typically Exchange Traded Funds (ETF) or Exchange Trades Notes (ETN). They may also be designed to have various ratios to the daily movement of the VIX (for example 2 times or .5 times) in which case they are also referred to as leveraged or geared ETFs or ETNs.
ETFs are subject to specific risks, depending on the nature of the Fund. The Fund may buy or sell options on volatility related ETPs, such as: (referenced positions are subject to change and should not be considered investment advice)
SVXY: ProShares Short VIX Short‐Term Futures ETF seeks daily investment results, before fees and expenses, that correspond to the inverse (‐1x) of the daily performance of the S&P 500 VIX Short‐Term Futures Index.
VXX: The iPath S&P 500 VIX Short‐Term Futures ETN tracks an index with exposure to futures contracts on the CBOE Volatility Index with average 1‐month maturity.