Short volatility has become known as an alternative asset class, used by investors seeking to enhance their portfolios’ risk-adjusted return potential. Yet while short volatility has a positive correlation to equities and many use it as a hedge against equities, investing in short volatility comes with risk of substantial losses.
Here are a few things you need to know about short volatility.
Short volatility positions speculate that volatility will be relatively on the lower side. Investors who are short volatility may be compensated for tolerating risk over time, in exchange for suffering occasional losses.
The other side of the trade, long volatility, speculates that volatility will be relatively on the higher side. While it provides a hedge against equity exposure, long volatility has underperformed short volatility over the long term. This is because investors have tended to overestimate the duration and magnitude of volatility. There is of course no guarantee that strategies continue to perform similarly in the future, and as recently as February 2018, traditional short volatility products fell as much as 90%.
Since volatility typically remains low during bull markets, and may last for longer periods than bear markets, over the long term, the short‐volatility side of the trade has shown to be a better performing position than long volatility. Yet of course, again, there is no guarantee this behavior will continue into the future.
Traditional products offering exposure to short volatility come with the risk of substantial losses because they are index‐based. When volatility spikes, it’s not uncommon for short‐volatility investments to lose 20% or even up to 90% of their value in just a few trading days. Yet, spikes in volatility have been typically followed by mean reversion, including during some of the most volatile periods in history—the Great Depression of the 1930s, the financial crisis and resulting market crash of 2008‐2009 and Brexit (i.e., the United Kingdom’s decision to leave the European Union) in 2017.
Traditional products offering exposure to short volatility, such as Exchange Traded Products (ETPs) or futures are designed to be short‐term, tactical trades and not to be held over the long term. This is because the risk exists of a large spike in volatility that could not only wipe out any prior gains, but also wipe out the investment itself. In fact, in February 2018, no less than seven products offering exposure to short volatility crashed and burned.
Before February 5, 2018, ETPs investing in short volatility were drawing record inflows and attracting a great deal of media attention. These strategies, however, are not meant for long‐term exposure, but are designed as short‐term tactical investment vehicles.
Measured Risk Strategy Fund, launched in December 2016, is not a direct investment in short volatility. The Fund seeks to outperform the S&P 500 over the long term by purchasing options linked inversely to volatility. During volatility spikes, these options may lose up to 100% of their value. Yet by limiting this “high risk component” to a small percentage of the portfolio, the Fund attempts to avoid catastrophic losses, especially over short periods of time. The underlying movement of the Index offers the potential for significant gains that may counterbalance losses and provide an opportunity for net positive return over time.
Investors should carefully consider the investment objective, risks, charges and expenses of the Measured Risk Strategy Fund. Mutual funds involve risk, including possible loss of principal. There is no guarantee the Fund will meet its objective. This and other information is contained in the prospectus and should be read carefully before investing. For a prospectus please call Measured Risk Portfolios at (855) 907‐3407 or at www.mrp.fund. The Funds are distributed by Northern Lights Distributors, LLC, member FINRA / SIPC. Northern Lights Distributors, LLC is not affiliated with Measured Risk Portfolios, Inc. 4254-NLD-2/6/2019
Important Risk Information: 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. If unhedged, written calls expose the Fund to potentially unlimited losses.
The Fund is nondiversified and as a result, changes in the value of a single security may have a significant effect on the Fund’s value. Other risks include U.S. Government securities risks and investments in fixed income securities. Typically, a rise in interest rates can cause a decline in the value of fixed income securities or derivatives owned by the Fund. 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. ETPs are subject to specific risks, depending on the nature of the ETP. 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 and VXXB.