Latest / The Bear Market Podcast with Fexingo: Surviving Downturns, Buying the Dip, and Long-Term Resilience / The Hidden Fallacy in Volatility Targeting Strategies
Transcript
- Lucas: So, the VIX is at 14.43, down eight and a half percent this week. Calm, right? But the VVIX is at 86.63. That's the volatility of the volatility, and it's only down six and a half percent. That gap, that sticky VVIX, is what I want to dig into today, because it exposes a real flaw in how a lot of volatility-targeting strategies operate. Luna: You mean the strategies that automatically cut exposure when the VIX spikes? They sound sensible in theory. Lucas: Exactly. The logic is simple: measure the VIX, if it goes above a threshold, reduce equity exposure. It's built into risk parity funds, volatility-controlled ETFs, even some pension fund allocations. The problem is, those strategies are calibrated to the level of volatility, not to the volatility of volatility. And when the VVIX is high, meaning swings in the VIX are large, the VIX can spike and collapse within days. The strategy ends up selling after the crash and buying back after the recovery. Luna: So it's a whipsaw machine. Sell low, buy high, systematically. Lucas: Right. And I've got a concrete example from August 2024. On August fifth, the VIX spiked to around sixty-five, a massive jump. A typical volatility-targeting strategy would have cut equity exposure to maybe twenty percent or less. But then the VIX collapsed back to about fifteen within a week. So the strategy would have been forced to buy back at much higher prices. That's a structural drag, not just bad luck. Luna: But doesn't that kind of strategy protect you on the way down? You're avoiding the worst of the crash. Lucas: You're avoiding part of it, but the timing is off. The VIX doesn't spike at the peak; it spikes after the market has already dropped. So you're selling near the bottom, not near the top. Then you're buying back after the recovery. Over time, that eats into returns. There's a reason why studies show volatility targeting adds value in low-vol regimes but tends to underperform when volatility is itself unstable. Luna: And the VVIX is measuring that instability. At 86, it's still high historically, even though the VIX is low. So the market is telling us that big swings in the VIX are still likely. Lucas: Exactly. And that's why the VVIX matters more than the VIX right now. A calm VIX with a hot VVIX means the system is prone to sudden, sharp volatility spikes. For a volatility-targeting strategy, that's the worst possible environment. It's like a fire alarm that goes off randomly — you either ignore it and burn, or you evacuate every time and end up standing in the rain all day. Luna: So what's the alternative? Is there a smarter way to use volatility signals? Lucas: Some funds are starting to use the VVIX as a filter. Instead of reacting to the VIX level alone, they only cut exposure when both the VIX and the VVIX are elevated. Or they use the term structure of VIX futures. The idea is to avoid selling into a spike that's going to revert quickly. It's not perfect, but it's more nuanced than a simple threshold. Luna: But doesn't that add complexity? The whole appeal of volatility targeting is its simplicity. Lucas: It does, and that's the trade-off. Simple rules are easy to implement and easy to explain to a board. But they're also easy to game and easy to break. The market is not static. A rule that worked in 2019 may not work in 2026. That's the deeper lesson: even 'systematic' strategies require human judgment about when to override the system. Luna: And that's hard because human judgment is exactly what most investors are trying to remove when they go systematic. Lucas: Right. But here's the thing — the best approach is a hybrid. Use the systematic rules to handle the boring, day-to-day risk management. But keep a human in the loop for the tail events, because that's when the system is most likely to fail. I've seen it in practice: the funds that navigated August 2024 best were the ones that had a manual override built in. Luna: So, if someone is using a volatility-targeting fund in their portfolio, what should they watch for? The VVIX? Lucas: At the very least, understand what the fund's rule is. Does it react to the VIX level? Does it react to changes in the VIX? Does it use VIX futures? That tells you how it will behave in a spike. And then look at the VVIX as a warning light. When it's high, expect the fund to be whipsawed more than usual. It's not a reason to abandon the strategy, but it's a reason to adjust your expectations. Luna: So, maybe hold a bit more cash during those periods? Lucas: That's one approach. Or tilt toward strategies that don't rely on volatility signals, like a simple buy and hold with a fixed risk budget. The point is, don't assume the algorithm is smarter than the market. It's a tool, not a crutch. Luna: It's funny, we talk so much about the VIX and VVIX on this show, and yet so many investors still treat them as mysterious black boxes. Lucas: Yeah, and that's part of why we do this. We try to pull back the curtain a little. And actually, that reminds me — a quick honest thing. This podcast is ad-free, and it's only possible because a small group of listeners chips in every month through buy me a coffee dot com slash fexingo. That's buy me a coffee dot com slash fexingo. It literally funds the time we put into researching these episodes. So if you've gotten value from any of these conversations, that's how you can keep it going. No pressure, just an option. Luna: Yeah, and we really appreciate the hundred or so of you who already do. It's what keeps this show independent. Lucas: Alright, back to the whipsaw problem. Because there's another layer to this that I find fascinating: the interaction with the broader market. When volatility targeting is widespread, it can amplify market moves. Everyone sells at the same time when the VIX spikes, which makes the spike worse. That's a systemic risk, not just a personal one. Luna: So in a way, the strategy itself contributes to the volatility it's trying to avoid. Lucas: Exactly. And that's even more reason to be cautious about relying on it blindly. The more crowded the trade, the worse the feedback loop. It's not just about your own returns; it's about the stability of the whole system. Luna: So what's the takeaway for an average investor? Should they avoid these products altogether? Lucas: Not necessarily. They can serve a purpose for risk control, especially for people who can't stomach big drawdowns. But understand the tail risk. When the VVIX is high, expect whipsaw. And maybe have a plan for overriding the system or reducing your allocation. The worst thing is to be surprised by the behavior of a product you thought was automatic. Luna: So, a little skepticism is healthy. Lucas: Always. And that's the connective tissue to our earlier episodes on the VIX drop luring dip buyers into a trap. The same dynamics — low volatility, high volatility of volatility — are at play. It's all about recognizing that the calm surface hides a turbulent undercurrent. Luna: And that's a good note to end on. Thanks for the perspective, Lucas. Lucas: Thanks, Luna. And to everyone listening, keep questioning the tools you use. The market is always one step ahead.