Market Timing via the VRP?

Stock Market Returns and the Variance Risk Premium

January 2021. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Stock market returns were highly positive when the variance risk premium (VRP) was negative
  • Returns were slightly negative across markets when the VRP was positive
  • This relationship can not be exploited for market timing

INTRODUCTION

The US stock market in 1999 and 2020 had probably more similarities than differences. In both years the market was up considerably, retail investors were highly active, and technology companies were the most sought-after stocks. Euphoria was high and valuations seemed rather trivial for the stocks featuring attractive growth prospects.

A more nuanced similarity was that the market volatility was above average in both periods, which can be considered rather unusual. The VIX ended at 23% in 2020, which is greater than the long-term average of approximately 19%. Typically rising stock markets are associated with declining volatility. 

Perhaps this is a reflection of continuing concerns about the impact of COVID-19 crisis on the global economy. It might also be a sign of the significant inflow of retail investors participating in options markets, which is also seen in a large difference between implied and realized volatility, commonly called the variance risk premium (“VRP”). These investors are aggressively buying calls to generate even higher returns than with stocks as well as puts to hedge their gains. Either transaction increases the demand for options and implied volatility (try Finominal’s Volatility Optimizer for risk optimization).

The VRP is currently elevated, similar to in 1999. So, should investors be concerned? After all, stocks, especially the beloved technology stocks, crashed severely post the turn of the century.

In this short research note, we will explore the relationship between stock market returns and the variance risk premium.

THE GROWTH IN ASSETS OF SMART BETA QUALITY ETFS

The variance risk premium has been approximately 3% in the US in the period from 2002 to 2020. Investors can buy the spread from investment banks and asset managers that offer variance risk premia products. The sales pitch is that the spread is mostly positive