2015 proved to be an extremely difficult year for volatility strategies generally. The reasons are not difficult to fathom: the sea-change in equity markets resulting from the Fed’s cessation of quantitative easing (for now) produced a no-less dramatic shift in the volatility term structure. During the summer months spot and front-month volatility surged, producing an inverted term structure in VIX futures and causing havoc for a great number of volatility carry strategies that depend on the usual downward-sloping shape of the forward volatility curve.

Performance results for many volatility strategies over the course of the year reflect the difficulties of managing these market gyrations. The blog site Volatility Made Simple, which charts the progress of 24 volatility strategies, reported the year-end results as follows:

While these strategies are hardly the “best in class”, the fact that all but a handful reported substantial losses for the year speaks volumes about the the challenges faced by volatility strategies during periods of market turbulence. Simplistic approaches, such as volatility carry strategies, will tend to blow up when volatility surges and the curve inverts and the losses incurred during such episode will often undo most or all of the gains accrued in prior months, or years.

Although our own volatility ETF portfolio on any given day might bear a passing resemblance to some of these strategies, in fact the logic behind it is considerably more sophisticated. We take an options-theoretic approach to pricing leveraged ETFs, which allows us to exploit the potential for selling expensive Theta against cheap Gamma, while at the same time affording opportunities to take advantage of the convexity of levered ETF products (for a more detailed explanation, see Investing in Leveraged ETFs – Theory and Practice). We also mix together multiple models using different a wide range of data frequencies, in both time and trade space, and apply a model management system to optimize the result in real time (the reader is referred to my post on Meta-Strategies for more on this topic).

So much for theory – how did all this work out in practice in 2015? The following are some summary results for our volatility ETF strategy, which we operate for several managed accounts.

The substantial increase in annual returns during 2015 is largely a reflection of the surge in volatility during the summer months (especially July), although it is interesting to note, too, that performance also improved on a risk-adjusted basis during the year and currently stands at around 3.60. It is perhaps unlikely that the strategy will continue performing at these elevated levels in 2016, although volatility shows no sign of moderating yet. Our aim is to produce returns of 30% to 40% during a normal year, although 2016 could prove to be above-average, especially if the equity market corrects.

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