The Worst Hedge

VIX Sticks the Landing?

What was the worst-performing hedge of 2022? Obviously some may point to government bonds, although whether a core allocation should be considered a portfolio hedge merits a broader discussion.

A different contender must be products linked to VIX, the gauge of equity volatility based on S&P 500 options. VIX has traditionally been popular for hedging tail risks, as it should rise when fear drives volatility higher. But in 2022, risk-mitigating strategies using options on the VIX or rolling VIX futures incurred losses and were among last year’s worst hedges, in our view.

Conversely, the opposite trade worked well. Shorting VVIX (essentially the volatility of volatility, implemented by selling options on the VIX) returned as much as 60% in 2022 or 30-40% on a risk-adjusted basis.¹

One consequence of this divergence was that many more investors piled into the profitable trade and out of the loser. The selling pressure on the VVIX created an opportunity to buy VIX options in January 2023 at a level as cheap as it has been since 2017, the lowest-volatility year of the past half-century.²

Fast forward to the banking crisis in March, and we see that VVIX – having been trending lower amid the aforementioned dynamics – jumped only to around its post-Covid average (Figure 1). The absence of a more dramatic reaction suggests that equity investors, unlike their fixed-income counterparts , remain sanguine. Confidence could nevertheless prove premature. We recall that on the day Bear Stearns collapsed in 2008, the VIX edged lower. It was another four months before volatility surged (Figure 2).

Figure 1. VIX and VVIX

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Source: Bloomberg; as of 24 March 2023.

Figure 2. VIX Before and After the Bear Stearns Collapse

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Source: Bloomberg; as of 28 March 2023.

The Bear Case

On the subject of Bear Stearns, it may be instructive to revisit the 2007-08 timeline (Figure 3). In June 2007, Bear bailed out a number of subprime hedge funds via a $3.2 billion collateralised loan.³ Bank equities in general didn’t seem perturbed by that. It wasn’t until those hedge funds failed around a month later that concern mounted.

By March 2008, events were starting to resemble what has transpired 15 years later. The Federal Reserve intervened to support a sale with a $30 billion lending facility, but even that backstop proved insufficient and so, in the course of a single weekend, Bear Stearns ended up being acquired at a huge markdown for its shareholders. The narrative at the time was that Bear’s assets had been sold extremely cheaply and represented good value. Sound familiar?

Nevertheless, we wouldn’t extrapolate exactly the same denouement for the banks left standing this time. First, it doesn’t seem that either SVB or Credit Suisse had the same degree of toxicity on their balance sheets. Second, the acquiring banks seem to have left more of the risk in their deals with the authorities, either by leaving the worst assets in the regulator’s hands or by formally sharing liability beyond a given threshold.

Figure 3. KBW Nasdaq Bank Index, 2006-2009

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Source: Man Group and Bloomberg; as of 28 March 2023.

With contribution from: Peter van Dooijeweert (Man Solutions – Head of Multi-Asset Solutions)

1. Source: Man Group calculations based on Bloomberg data; as of 28 March 2023.
2. Source: Man Group calculations based on Bloomberg data; as of 28 March 2023.
3. Source: Reuters,22 June 2007.