Diversification of Equity with VIX Futures: Personal Views and Skewness Preference

Abstract

A comprehensive description of the trading and statistical characteristics of VIX futures and their exchange-traded notes motivates our study of their benefits to equity investors seeking to diversify their exposure. We analyze when diversification into VIX futures is ex-ante optimal for standard mean-variance investors, then extend this to include skewness preference, and a moderation of personal forecasts by equilibrium returns, as in the Black-Litterman framework. An empirical study shows that skewness preference increases the frequency of diversification, but out-of-sample the optimally-diversified portfolios rarely out-perform equity alone, even according to a generalized Sharpe ratio that incorporates skewness preference, except during an extreme crisis period or when the investor has personal access to accurate forecasts of VIX futures returns.

Keywords: Black–Litterman Model, mean–variance criterion, optimal asset allocation, SPY, roll cost, VIX futures, VXX, volatility ETNs

JEL Classification: G11, G15, G23