Thursday, November 14, 2013

How Does VolDex Stack Up to the VIX?

By Tim Dulaney, PhD, FRM and Tim Husson, PhD

We've talked a lot about the idea of using volatility to hedge equity exposure.  The basic finding, from our research work and that of others, is that the CBOE Volatility Index (VIX) hedges the S&P 500 fairly well.  Unfortunately, the VIX is not investable, but is a complicated calculation based on a large strip of options contracts -- i.e., contracts of varying moneyness.  Proxies for the VIX, such as rolling VIX futures strategies, are much worse hedges and have a number of problems that make them extremely unattractive investments.*

NationsShares, an index provider that specializes in options-based indexes, is now providing a new volatility index called the Nations VolDex Index (ticker: VOLI).  Instead of using a broad strip of options contracts, VolDex only looks at "the implied volatility of a precisely at-the-money option due to expire in precisely 30 days" linked to SPY, the largest S&P 500 exchange-traded fund (ETF).  NationsShares claims that not only is this SPY option more liquid than the VIX's SPX options, but that by calculating implied volatility of a single option means that their index can be replicated relatively simply.

While the differences between the VIX and VolDex might seem technical, they are actually very significant.  The CBOE has responded to some of the claims made by NationsShares in a recent piece, specifically noting that the VIX does not measure implied volatility (a point we have made numerous times ourselves), but prices future S&P 500 variance.   In fact, when the VIX was first issued in the early 1990s, it did use implied volatilities, but revised its methods in 2003 to bring it more in line with the academic literature (PDF) on variance swaps.  The CBOE also clarifies a few misconceptions that NationsShares seems to be encouraging through the marketing of their index.

One major difference between the VIX and VolDex that the CBOE does not discuss is exposure to volatility skew.  Volatility skew is the empirical observation that the implied volatility of options contracts tends to vary with different strike prices, such that out-of-the-money and in-the-money options have markedly different implied volatilities.  For some background, you can check out our paper (PDF) on volatility skew in leveraged and inverse leveraged ETF options.

VOLI will not incorporate any information about volatility skew because it only looks at one strike price -- the 'at-the-money' option.  On the other hand, the VIX includes many in- and out-of-the-money options in its calculation.  Nations claims that this skew effect is "statistical noise", and has even created a separate index -- the Nations SkewDex Index (PDF) -- to measure it.  It has been noted before that the VIX does tend to overestimate actual volatility; however, the academic literature notes that volatility skew is important to accurately pricing variance swaps, which is why it is incorporated into the VIX methodology.

Furthermore, VolDex uses a proprietary algorithm for calculating implied volatility from observed options prices.  The VIX methodology is highly complex, but fully disclosed in the CBOE's white paper.  The International Securities Exchange has entered into a licensing agreement to list cash-settled European options linked to VolDex, and may also offer options, futures, or exchange-traded products linked to the index as well, meaning that retail investors may soon be able to purchase access to this index.  However, unless NationsShares publishes the full methodology, investors will not be able to fully understand what their underlying exposure actually is.

It will be interesting to see if VolDex is adopted by traders and analysts, as well as how it responds relative to the VIX during spikes in volatility.  It will also be interesting to look at its ability to hedge equity portfolios, as so many other products have tried to do using VIX derivatives.  However, there are many reasons to believe that its relationship to S&P 500 volatility will be less clear than the current standard.
*  For related research, see our paper "Are VIX Futures ETPs Effective Hedges?" (PDF) which appeared in the Journal of Index Investing in winter 2012 (Vol. 3, No. 3, pp. 35-48).

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