This index is created through the hypothetical strategy of rolling a short position in 3 month variance futures. The strategy is based on the observation that realized volatility is almost always lower than market implied volatility or variance.
In normal times, the slope of the return graph is remarkably constant. According to CBOE, “Since its inception, VARB-X has reflected an annual rate of return of 19.0% with a standard deviation of 6.4%”. However, the return is susceptible to huge losses in the event of a volatility spike (like Flash Crash or 2008).
If you could somehow control for the huge drawdowns, then the concept sounds pretty interesting.
Pretty cool. I’m not sure how much I consider this arbitrage, more like exposure to the variance risk premium.
Precisely the reason why this strategy is profitable is because investors are paying you to take tail risk. Another way to think of this is that it’s exactly the opposite of what Nasim Taleb does. In one of his books he wrote about how Neiderhoffer was basically running a similar short vol, but using straddles instead of the more pure variance approach that this relies on. I’m guessing if you took this back to the 90s, you’d see some huge swings around other market dislocations.
Looking at the white paper it seems that they make some rudimentary mechanical attempts to limit the drawdowns, but it certainly isn’t a complete strategy. You would need to be able to jointly model S&P500 returns, its volatility, and the implied volatility surface (there’s some funky cointegration between those three) and then price all the calls/puts and variance futures. I wouldn’t be surprised if you could come up with some kind of combination of those assets that doesn’t lose as much money when realized volatility is much higher than implied volatility, or a way to evaluate when it is those kinds of periods (just speculating, but it suggests that the cointegrating relationship between implied and realized volatility adjusts depending on the level of volatility).