The Variance Risk Premium: What Premium?
The Challenges of Realizing Theoretical Returns
June 2020. Reading Time: 10 Minutes. Author: Nicolas Rabener.
SUMMARY
- Harvesting the variance risk premium has a sound theoretical foundation
- However, actual investment products have generated poor returns
- Furthermore, they are correlated to equities, providing few diversification benefits
INTRODUCTION
Investing is akin to fighting in a never-ending war. There are long periods of peace and prosperity, but investors are frequently drawn into short-term combat, extended battles, and multi-year wars. And the cycle repeats over and over.
For some of the foot soldiers, the COVID-19 crisis in 2020 represented the first time in the trenches while many of their captains are still scarred by the global financial crisis of 2008. Experienced majors painfully recall the tech bubble implosion in 2000 and a few select generals lived through the sudden stock market crash in 1987 at the start of their careers.
However, even the bravest soldiers and most experienced generals get tired of intense warfare. The COVID-19 crisis represents the third major stock market crash in a mere 20 years. Given this, investors can not be blamed for trying to mitigate potential damage to their portfolios by diversifying into alternative asset classes and strategies with unproven live track records.
Currently, asset managers pitching new and unique weapons for the investors’ arsenal are finding an especially receptive audience. One of the more esoteric alternative strategies is harvesting the variance risk premium (“VRP”), which one firm has been marketing as the following:
“Product XYZ opens up the risk premium of volatility to investors using a short volatility strategy. The return drivers of this strategy differ from those of traditional asset classes. Adding volatility strategies to existing portfolios thus enables positive diversification effects.”
Naturally, these are highly attractive attributes for asset allocation. However, many highly hyped weapons have failed investors in previous wars, cautioning the more experienced investors on strategies that sound too good to be true (read Thou Shall Not Short the VIX).
