Banks are using volatility products with transparent structures and pay-offs that are easy to understand to attract a growing number of institutional and individual investors.

A new generation of products are making access to volatility as an asset class much simpler, and bringing in a growing number of institutional and ultra-high-net-worth individual investors. Typical underlying assets for these products are futures on the VIX and VSTOXX, volatility indicators for the US S&P 500 and European EuroSTOXX equity indices, respectively.

These individual investors want to make allocations to volatility in their portfolios, for example, to hedge against extreme events that fall into the tail-risk category. But unlike hedge funds, they do not have the resources to construct their own strategies in the futures and options markets.

First-generation challenges

The first generation of volatility products that launched several years ago faced two challenges. First, it has been difficult to achieve a high beta – a close correlation with the actual daily movements of the VIX, which is a synthetic option based on prices paid for calls on the Chicago Board Options Exchange (CBOE), or its European equivalent VSTOXX.

Secondly, the negative roll yield associated with the continuous rolling over of futures positions has eaten into returns for investors holding long-term structured products. Holding short-dated futures in quiet markets can be very expensive due to the contango of the curve: investors must pay a premium each time they roll into the next month’s future.

But investment banks have been fine-tuning their structures. The new versions of volatility products are designed to make the rolling of contracts more efficient, while increasing the correlation to the actual movements of the CBOE Volatility Index or VSTOXX.

Bankers believe that the intellectual argument about including long volatility exposure in overall equities portfolios has been won. The key to broadening the base of pension funds, asset managers, insurance companies and family offices using volatility products is to provide them with transparent structures with pay-offs that are easy to understand. Investors are wary of black-box structures, and they also want to see good secondary market liquidity.

In the current environment, controlling the volatility of portfolios is very important to investors

Stephane Mattatia

Purpose-built index

In April 2011, Société Générale Corporate and Investment Banking (SGCIB) launched an exchange-traded fund (ETF) based on the S&P VIX Futures Enhanced Roll Index. The Enhanced Roll mechanism was initially suggested by SGCIB, but was developed in co-operation with Standard & Poor's using its existing VIX indices. The strategy aims to minimise the carry-cost of rolling futures positions, while maximising returns whenever VIX has a major spike.

The ETF was initially launched in France, but is in the process of receiving its regulatory passport to other EU countries. It trades on the Euronext during the overlapping hours that both the French and US markets are open, so that trading is simultaneously taking place in the underlying VIX futures and options.

"Our aim was to create a transparent product that fund managers can view as a generic long volatility position, and is quoted intraday," says Stéphane Mattatia, head of flow equity derivatives engineering at SG CIB in Paris. "We have had a good response from clients who want access to volatility exposure but are aware that the carry-cost can be very expensive."

Smoothing performance

When volatility spikes, the index shifts more into short-dated futures, because they are the most reactive and will closely follow the VIX spike. But when volatility subsequently falls, short-dated futures will also drop fast, whereas medium-dated futures will be more resilient, so it is better to have an exposure to medium-dated futures. And in a quiet market environment, it is best to be invested in medium-term futures since the carry-cost of rolling the futures contracts is lower.

Investors want to see simple rules-based signals for the re-allocation of futures positions, and the product adjusts according to the level of the VIX versus its 15-day moving average. If it goes to 135% of the moving average then an allocation is shifted into short-dated futures, but when it goes back down to the 15-day moving average, this is the signal to shift back into medium-dated futures.

"We have done some simulations and, over the past five years, an allocation comprising 90% S&P 500 plus 10% S&P VIX Futures Enhanced Roll Index would have outperformed the S&P 500 by 18%," says Mr Mattatia. "In addition, paradoxically, if you include volatility as an asset class in your overall equities portfolio, the volatility of the portfolio is reduced. And in the current environment, controlling the volatility of portfolios is very important to investors."

Analysts point out that VIX has been shown to be negatively correlated to the equity market, mainly because when markets drop investors generally rush to buy downside protection. This means there is more demand on implied volatility, which causes its price to increase.

Dynamic approach

Credit Suisse has also been working on new-generation volatility products. Last November, the investment bank launched a suite of six VelocityShares VIX Exchange Traded Notes (ETNs) under names such as VIIX and TVIX. The notes are linked to either the S&P 500 VIX Short-Term Futures Index, which offers exposure to a daily rolling position in the first and second month VIX futures contracts, or the S&P 500 VIX Mid-Term Futures Index, which offers exposure to a daily rolling position in the fourth, fifth, sixth and seventh month VIX futures contracts. The four long-exposure products can be either one or two times leveraged. The other two products give inverse exposure.

"Investors want access to volatility to hedge tail risk, but they need structures to play it more efficiently," says Chan Ahn, head of equity derivatives structuring at Credit Suisse in New York. "We dynamically manage the futures positions to more closely match movements in the VIX, and also to reduce the negative roll yield."

"The two-times leverage products are also long volatility, but they are designed for investors with a very short trading horizon of maybe a few days, so the carry-cost is less of a problem," says Mr Chan. "These investors use ETNs as building blocks to help construct strategies, and so are very concerned about the beta. We use two times leverage to make the ETN behave very much like the VIX, with a high beta of 0.8 or 0.9."

The third pair of products are for investors who want to take a short volatility position. The XIV ETN gives inverse exposure to the VIX S&P 500 Short-Term Futures Index. These products have been constructed to closely mirror daily movements in the VIX, so that if it spikes by 10% the XIV should fall by close to 10%.

VIX volatility of Standard & Poor's 500 US Stock Market Index

First mover

In recent years, Barclays Capital has carried out much of the groundbreaking work in providing easy access to volatility with its VXX and VXY products, which were launched in January 2009. These early products helped broaden the investor base for volatility exposure, but had some inefficiencies such as high carry-costs associated with rolling the futures contracts, and low beta in some circumstances, so were not always a strong proxy for the VIX.

Nonetheless, the basic product engineering done by Barclays Capital has been widely used by rival investment banks, providing the foundation for the next generation of products. In addition to offering a new set of VIX ETNs under its iPath brand, since April 2010 Barclays Capital has been offering investors products which give exposure to European equities volatility via its iPath VSTOXX Short-Term Futures ETN and iPath VSTOXX Mid-Term Futures ETN.

The benchmark VSTOXX index and the underlying VSTOXX Futures Indices are calculated by the independent index sponsor, STOXX Ltd. The VSTOXX Short-Term Futures Index is based on the first and second month VSTOXX futures, and rolls daily. The VSTOXX Mid-Term Futures Index is based on the fourth to seventh month futures, and rolls daily between the fourth and seventh month futures, while holding constant exposure to the fifth and sixth month contracts.

"Some investors have traditionally looked towards VIX as a global measure, assuming that if there was volatility in Europe it would probably be reflected in the S&P 500," says Natasha Jhunjhunwala, vice-president in equity and funds structured markets at Barclays Capital in London. "But the increased volatility seen in May 2010 was a European phenomenon which had little impact on the S&P 500."

"VSTOXX products enable investors to isolate exposure to European volatility," says Ms Jhunjhunwala. "Global investors may choose to use a combination of VIX and VSTOXX volatility products, but if they had to pick one, many European clients are now choosing VSTOXX to include in their global portfolio."

Over the counter

Having products listed is a growing trend since the financial crisis, because of liquidity concerns, but banks are also offering a range of bespoke trades to asset managers, as well as products that trade over the counter (OTC). Some leveraged products would not typically be suitable for listing requirements.

In March 2011, Société Générale Index (SGI) launched a flagship VIX index called Vinci, which aims to provide efficient exposure to the VIX, limit the cost of carry, and also mitigate the risk of a downside correction following a volatility spike. Vinci is an index of Société Générale, and is maintained and calculated by S&P. The strategy is available in various formats, such as collateralised notes or standard swaps.

SGI Vinci combines two positions on VIX futures contracts. A long position, the beta component, gives efficient exposure to the implied volatility of the S&P 500 with an optimised roll strategy. But there is also a term structure position, the alpha component, which combines a long position on VIX futures, also using an optimised roll strategy, with a short position on a standard roll strategy.

"The aim of SGI Vinci is to offer a solution that gives easy access to volatility with a transparent set of rules, allowing investors to make a small cash allocation to the instrument while giving leveraged exposure that will hedge a large part of an equities portfolio," explains Marc Pantic, head of Société Générale Index in Paris.

"Since launch, we have been getting good feedback from equities portfolio managers such as pension funds, third-party asset managers and discretionary mandates," says Mr Pantic. "We have been doing private placements and OTC trades, and since investors are clearly very concerned about volatility, we see a potentially large market for this type of product as a hedging instrument."

Dividend products

Investors are also increasingly interested in implied dividend products. As with volatility exposure, the key to a successful product is to simplify access to an implied asset that is difficult to buy directly. EuroSTOXX implied dividend futures have been trading since 2008 and provide a liquid underlying instrument upon which structured products can be based.

In Europe, the sale of dividend flows has been associated with the decade-long rise of structured products, since bank issuers wanted to hedge the dividend risk associated with their structured products, most notably those based on the EuroSTOXX 50. This exposure was traditionally sold OTC to hedge funds, but the growing liquidity of dividend futures had made access much easier to a broad group of investors.

"In 2008, Eurex launched dividend futures, and since then structured products have made access to implied dividend exposure much easier for high-net-worth clients, who are less likely to construct their own dividend trades the way hedge funds do," says Ms Jhunjhunwala at Barclays Capital.

"We have been doing tailored trades for high-net-worth clients, such as products providing capital protection wrapped in a structured note," she adds. "The futures market currently implies that dividends will be lower in 2014 than in 2012, so there is scope for trades such as steepeners, for example buying 2014 futures and selling 2012."

Natasha Jhunjhunwala

The increased volatility seen in May 2010 was a European phenomenon which had little impact on the S&P 500

Natasha Jhunjhunwala

Know your product

When equity markets collapsed in 2008, pricing on dividends also fell, but as stocks staged a recovery, dividend futures were still pricing in very low dividends. A number of investment banks are now offering their clients direct access to dividend exposure. In October 2010, Royal Bank of Scotland (RBS) launched the EuroSTOXX 50 Index Dividend Futures Turbo Long products, which are leveraged structured products giving investors long exposure to implied dividends.

"We are seeing growing demand for dividends as an alternative asset class to equity from European investors," says Ronald Van Der Ham, custom index structurer at RBS in London.

The range of new products on offer from investment banks, and their marketing efforts, is steadily increasing the investor base for implied dividends. Charles de Boissezon, head of global equity flow advisory at Société Générale in Paris, says a growing number of investors are inherently interested in dividend exposure, but there is an education process about what the dividend futures products can deliver.

"Products backed by dividend futures are not generating an income stream to produce a yield – investors are simply getting exposure to implied dividends,” says Mr Boissezon.

Bearish future

At present, the EuroSTOXX 50 dividend futures curve implies that dividends will be flat in 2012 compared with this year, and then will go down in 2013 and down again in 2014.

"Part of this is due to medium-term bearishness and part to the structural asymmetry between supply and demand in the dividend futures market. We have had a lot of interest in our Lyxor ETF based on EuroSTOXX 50 dividend futures, which is designed to be simple, transparent and liquid," says Mr Boissezon.

In the Lyxor product, futures are rolled once a year so investors always have exposure to the next five years’ maturities. This eliminates some of the market technical aspects of pricing, so the investor can focus simply on whether they believe the economic recovery will lead to higher profits, and whether companies will pay more or less in the form of dividends.

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