This is a matrix that outlines the correlations between the various asset classes

between 2004-06 and 2007-08 in parentheses. Note the increase in correlation

between 2007-08 relative to 2004-06. It’s a clear indicator there was much less of
a diversification benefit in ‘07-’08 than people believed they were getting. Plus,
the diversification wasn’t there at the time investors needed it the most. Only
Managed Futures had a negative correlation with Equities in ‘07-’08, which is
what you look for in diversification.

While all assets had positive correlations, it wasn’t a 1:1 relationship. I think most
of that difference is a function of relative liquidity of the asset classes to each
other.

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A great example of what I call a “quant fallacy” – correlations between assets are
constants. Correlations can be treated as constants for a short timeframe given
that there’s little volatility in the market. Otherwise, it’s a variable to be
measured/monitored on an ongoing basis.

2
This slide shows why buying VIX futures doesn’t work. Being long on volatility
without recognizing its mean-reversion properties is not a money-making
strategy. Over the long-term, you’ll lose as much as you gain because of this
simple fact regarding volatility. To borrow that line from the Ronco Rotisserie
Roaster (c’mon, you know the one), you just don’t “set it and forget it.” You need
an active approach.

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A few points:

•VIX Futures standard deviation is highest among asset classes here & along with
Real Estate and Private Equity, VIX Futures had the lowest % of Up days
•However, their returns were third behind Managed Futures & Bonds. Granted,
those two asset classes had some better risk characteristics, but this is another
way of underscoring that VIX assets can give true diversification benefits, but due
to volatility’s mean-reverting properties, standard deviation will be higher.
•Note the return in VIX Futures for the much shorter window from 8/2008 –
12/2008. Standard deviation actually fell while Equity, Private Equity, Real Estate,
& High Yield Bonds saw their standard deviations increase.

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In the world of portfolio management, this is a well-worn figure – the efficient
frontier. The goal, of course, is to find build a portfolio that lies at a point
anywhere on the frontier. Outside the frontier is not possible, but you definitely
don’t want to be inside the frontier, either. That’s a sign that your portfolio is
taking on excessive risk or achieving sub-optimal returns. But in most cases both
are probably happening.

Note the risk/return profile of the 100% Stock/Bond/Alternative portfolio.

Compare that to a 75% Stock/Bond/Alternative, 25% VIX Futures portfolio. For a
15% increase in standard deviation/risk, you get almost a 5-fold increase in
return. Seems like a good trade-off to me.

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Here’s another efficient frontier, this time the VIX exposure comes through at-the-
money (ATM) VIX calls. Risk/return is improved, but not enough bang for my
buck at 2.5% ATM VIX calls. 1% is nice, because volatility of returns are reduced
as well as a 100 bp gain in return.

An active approach with this asset class is key.

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Here, the VIX calls are out-of-the-money by 25% (so the calls are still long
volatility an additional 25% to the upside). In episodes of extreme fear and panic,
the force/violence of the move is just as important as the direction – possibly
more so. To see that a 2.5% weighting doubles volatility but annualized return
increases 10% (for the entire 3/2006-12/2008 timeframe, return increased
nearly 29%), it makes sense to have a VIX weighting in your portfolio. But, it has
to be actively managed for maximum benefit.