The Hazards of Volatility Diversification

Abstract

Recent research advocates volatility diversification for long equity investors. It can even be justified when short-term expected returns are highly negative, but only when its equilibrium return is ignored. Its advantages during stock market crises are clear but we show that the high transactions costs and negative carry and roll yield on volatility futures during normal periods would outweigh any benefits gained unless volatility trades are carefully timed. Our analysis highlights the difficulty of predicting when volatility diversification is optimal. Hence insitutional investors should be sceptical of studies that extol its benefits. Volatility is better left to experienced traders such as speculators, vega hedgers and hedge funds.

Keywords: Black-Litterman Model, Institutional Investors, Mean-Variance Criterion, Optimal Asset Allocation, SPY ETF, VIX Futures

JEL Classification: G11, G15, G23