Volatility Controlled Indices (VCIs)
Several years ago, I was sitting in a conference room listening to a representative from a major wire house talking about something called a Volatility Controlled Index (VCI).I was curious what this non-S&P 500 index option was all about. The representative talked about how their money managers could track market trends daily, and their ability to move money from equities to bonds (or bonds to equities) when their proprietary algorithm was triggered by market volatility. Their rationale behind this proposition (in addition to their self-proclaimed crystal ball reading
Similar to Dollar Cost Averaging and the diversifying of a managed portfolio, VCIs smooth out the ups and downs and in theory, limits the number of 0.00% returns an index could have (assuming a 0.00% floor). The theoretical trade off is that you would reduce your 0.00% crediting years in exchange for giving up some of your upside.
The reason I say the trade off is only theoretical is that an index with a 0.00% is already protecting your downside in exchange for a limitation in the maximum allowable return credited in a given year (the cap). This Floor & Cap proposition already manages volatility. To then manage the volatility within an already volatility-managed construct never made any sense to me.
In a Floor & Cap proposition with an IUL, volatility is actually your friend. Historically speaking, the S&P 500 – during 40-year period between 1984-2023 – produced thirty positive returning years (75.00%). Of those thirty positive returning years, twenty-six were greater than 8.00% and twenty-one were greater than 10.00%. There were only four years (out of those thirty positive returning years) that produced a return less than 8.00%.
My point is that hitting the cap during the large majority of positive returning years offsets the 0.00% return years and potentially creates a nice positive arbitrage. In a VCI, you just don’t have the upside potential during positive returning years the way you do in an S&P 500 index due to the lack of equities in the index – again, in theory.
Now, does this mean VCIs are bad?
Not at all.
VCIs are however under major scrutiny and criticism at the moment – some of which is warranted, and some not so much. One of the criticisms of VCIs is that they have been illustrating crediting assumptions based on multi-decade historical returns, despite the fact that some of these index options had only been created a few short years ago.
The rationale behind them using this backtested historical data was that it was possible to take the same index components (the actual equities and non-equities in the current VCI) and rebuild a clone of the VCI, tracking what the historical performance would have been had the VCI actually existed back then. But that is like a professional baseball team saying their scouting and player development program is superior because it would have picked Barry Bonds, Mark McGwire, Tony Gwynn, and Ken Griffey, Jr. in the 1980’s before they knew what kind of players they would develop into in the 1990’s. Knowing what we know now about these players, of course they would have drafted them back when they entered the draft.
Conversely, there have been several big-time prospects that many thought would become big league superstars, yet never reached their projected potential – players like Chipper Jones and Billy Beane. If we look at the historical returns of just a few VCIs compared to S&P 500 index returns using a floor and cap crediting method, it is very easy to take pieces of such data and draw assumptions that may or may not hold water over time.
It is also easy to manipulate statistics to fit a particular narrative, and though the statistics themselves may be true, the assumptions that are drawn out of these statistics may lead someone to believe something that is out of context.
As an example, it is a historically statistical proven fact that 100% of all human babies that drink cow milk die. This is an indisputable proven fact, and will remain true for the rest of human life on this earth. For the dummies reading this that don’t understand what I just stated (and for those that lack a sense of humor), all babies that drink cow milk will die… eventually, even if it is at age 100. There is no correlation between drinking cow milk and the certain death that all mortal human beings will face eventually, however the statistical statement – which is indisputably true and mathematically correct – can be misconstrued to fit the narrative that there is something deadly about ingesting milk from a cow.
Let’s take a moment to analyze some statistical, historically accurate data in regards to comparing the historical performance of a few VCIs with different Participation Rates (which varied from year to year) to the historical performance of an S&P 500-Correlated index with a 0.00% floor, a cap (which varied from year to year), and a 0.50% bonus.
The Pro-VCI Advocates will look at these numbers and gloat that the average returns of two of the three VCIs over the last five years have out-produced the S&P 500 index with the floor and cap, however that is only (and conveniently) only a 5-year period where their proposition proofed positive (similar to the baseball draft analogy I used earlier). But any reasonable person could easily argue that a 5-year period is far too short a window of time to draw any long-term assumptions from.
The Anti-VCI Critics will gloat that in 2023, the S&P 500 index with the floor and cap would have produced a 10.75% return, whereas the best producing VCI in that year only produced a 6.08% return. Their assumption might be that in today’s environment, VCIs are not appropriate. During high interest rate environments (similar to today’s interest rate environment), VCIs typically do as well as S&P 500 index funds with a floor and cap, however that does not mean that VCIs are bad.
But this Anti-VCI Critics’ gloating is based on Monday Morning Quarterback intel.
As a parallel example, building a portfolio that took heavy positions in of Blockbuster Video and Circuit City in the late 1990’s would have seemed pretty smart in the early 2000’s because of their historical success. However Circuit City filed bankruptcy in 2008, and Blockbuster Video closed their last store in the United States in 2019. It would be easy for a so-called stock market expert to say, “Nobody should have invested in these companies” after the fact, but that is a fool’s gloat.
It is easy to play Monday Morning Quarterback.
Now, there is – in theory – an advantage to having an uncapped upside the way many VCIs do. The concept of an uncapped upside means there is no limit to the gains you could make, however the fact that it is volatility-controlled means the equities allocation within the VCI is not as heavy as non-equities (like bonds).
As an example, in 2023, these are the equities-to-non-equities allocations of the three different VCIs I just mentioned.
As you can see, when the equities position is less than 30.00% within an indexed fund, the upside is going to be limited due to heavy diversification into non-equities. However, to offset the lower returns that typically come with heavy allocations in non-equities funds (like bonds for example), these aforementioned VCIs have Participation Bonuses that range from 190.00% to 215.00%.
In other words, if the VCI produced a gross return of 4.00%, assuming a 200.00% participation rate, the actual return in that year would be 8.00% (4.00% x 200% = 8.00%).
Most of these VCIs also have a 0.00% floor and an uncapped upside, so the 0.00% floor protects the downside… the uncapped upside doesn’t limit the upside potential (the way a capped index would), and the volatility-controlled component further mitigates risk, in theory. The proposition here is, “The VCI only needs to produce a 4.00% in order to get 8.00%. 4.00% is nothing.”
This proposition – though easy to explain – is not as simple in its construction.
As you saw in the historical comparison between VCI performance versus S&P 500 performance, there are several moving parts, and just because one may have worked better in select instances does not mean that one is necessarily universally better in all scenarios.
Perhaps you are wondering how these Participation Bonus rates are determined. In order for the index fund to offer a Participation Bonus, there is something called the Risk-Free Rate. Think of it as the cost or spread deducted from the gross VCI return. When VCIs first gained popularity, the Risk-Free Rate was 0.00%, however today’s Risk-Free Rates hover around 5.30% (similar to the SOFR rate or the FedFunds rate).
As an example, if the VCI with a 200.00% Participation Rate produced a 9.30% gross return, after the Risk-Free Rate cost deduction, the pre-Participation Bonus return would be 4.00% (9.30% - 5.30% = 4.00%). If the Participating Rate was 200.00%, the VCI index credit in such year would be 8.00% (4.00% x 200.00% = 8.00%).
As I said, that easy-to-explain articulation of Participation Bonus rates is not as simple as only needing a 4.00% return to get 8.00%. Back when the Risk-Free Rate was 0.00%, this simple statement was true. In today’s environment, it is not so simple.
So why was there such a heavy push in the industry advocating VCIs a few years ago?
This is purely speculative, however I think my logic is sound. Due to AG-49A, the regulators had their way with emasculating IUL illustrations, but what the regulators missed was the ability for a carrier to illustrated certain bonus assumptions in a VCI that was forbidden in an S&P 500 point-to-point illustration. This loophole allowed carriers to illustrate more favorable outcomes in a VCI illustration.
One of the things that has always driven me crazy in the life insurance industry is the fact that most advisors sell the client solely based on the numbers and outcomes depicted in the carrier illustration.Since most insurance agents are actually brokers – meaning they can sell virtually any insurance carrier they so choose – they will typically sell the carrier that shows the best outcomes in their illustration. This is such a poor method for a client to choose the carrier and IUL that is right for them.
As I mentioned in the chapter about backtesting, understanding the relationship between charges and the crediting methodology only truly becomes apparent when we backtest these assumptions during times of volatility. Just because one product performs better when using positive static return assumptions every year (the way a carrier illustration depicts outcomes) does not mean that same product will perform better than other alternatives during times of volatility.
Since there is not enough historical data with any of these new VCIs, I cannot provide a true backtesting report with a VCI. Again, this doesn’t mean that VCIs are bad. The reality is, you need to make a philosophical decision regarding diversification and risk mitigation when it comes to choosing either a VCI or an S&P 500 index allocation.
I have had some clients elect a VCI a couple of years ago because interest rates were low and the client speculated that the stock market would not produce a very good return.
Interest rates skyrocketed over the last couple of years and though the S&P 500 produced a negative return in 2023 (-19.44%), in 2023, it produced a positive 24.33% return. Their decision to opt for a VCI was not philosophically incorrect. They made the best decision they could at that time, and though they guessed wrong, it is not the end of the world. They have the ability to switch to an S&P 500-correlated index at their next policy renewal.
In summary regarding VCIs, it is foolish to say that they are better than S&P 500 index options, and vice-versa. Personally, I still stand by the philosophy I have had since the inception of VCIs (as well as Dollar Cost Averaging) – that there is nothing wrong with either of these strategies – however regarding IULs, I am philosophically opposed to both.
Always remember that in an IUL with a floor and cap, volatility is your friend.
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