In the bear market between the Septembers of 2000 and 2002, variance-selling strategies built to match the risk of the S&P 500 trounced that index, returning 45 per cent against -45 per cent. On average, the swaps priced in a 30 per cent monthly increase in realised market volatility, providing a thick cushion against underperformance.

But in steadily rising markets, or during a major repricing of risk, short variance strategies usually underperform. While the blended LIBOR-variance swap instrument had an average monthly return of -1.9 per cent, compared to the index’s -8.4 per cent during the 10 biggest calendar month declines in the S&P500 in the sample period from January 1996 to September 2007, when the index returns beat 4 per cent, volatility strategies underperformed. At their worst, the maximum monthly losses of variance swaps designed to have volatility levels of 5 per cent (lower than many hedge funds), 10 per cent (similar to at-the-money option-selling strategies) and 15 per cent (like the S&P500) turned out to be, respectively, -5.7, -12.0 and -18.3 per cent.