With major U.S. equity indexes setting new highs, some investors may be bracing for a major correction downward.
To hedge their equity positions, these investors may be tempted to reach for a VIX-based product. Products based on the CBOE Volatility Index, or VIX, are often used as equity hedges because the VIX and the S'P 500 Index tend to move in opposite directions.
However, a recent Bloomberg piece noted that this relationship—the strongly negative correlation between the VIX and the S'P 500—may be weakening.
The VIX may be the market’s leading measure of volatility and its mechanics are interesting, but they’re not actionable. Investors can’t access the VIX index—it’s uninvestable. Instead they gain exposure to it using VIX futures.
But VIX futures offer an imperfect vehicle for VIX index exposure due to the shape of the futures curve— as has been noted ad nauseum by analysts and bloggers, including me.
All this is preamble. When I saw the Bloomberg article, I immediately wanted to know whether correlations between VIX futures products and the S'P 500 had changed.
Cut To The Chase
Correlations change all the time. Here’s a graph of rolling correlations between the iPath S'P 500 VIX Short-Term Futures ETN (VXX) and the SPDR S'P 500 ETF (SPY). I used a 22-trading-day rolling period, equal to a calendar month. That’s a short window, but one that’s realistic for a tactical hedge using VIX futures products. On the chart, values approaching -1 (at the bottom) are ideal for hedging purposes.
While the chart doesn’t show a clear trend that negative correlation has decreased recently, it does show that correlations are increasingly unstable in 2013. The hedging power of VXX lies in strong negative correlation, and when this aspect of performance is less reliable, the hedge is less reliable as well.
I also ran rolling correlations over a longer time frame, namely 63 trading days or one calendar quarter. As you’d expect, the longer look-back shows a smoother line. And the weakest correlation is -0.69 for 63 days vs. -0.39 for 22 days.
This implies that holding VXX for a quarter rather than a month gives more hedging power. However, this approach creates another risk, namely the tendency for VXX as a stand-alone product to lose money even faster than Uncle Sam can print it. (VXX is down 73.2 percent over the past 12 months.)
This makes me think that a one-quarter look-back period is too long, and that the big money is in VXX for a few days rather than a few months. This notion is reinforced by VXX’s breathtaking turnover ratio (assets divided by average daily dollar volume) that’s roughly equal to 1. Yes, it turns over its entire $1 billion in just in a day or two.
All this suggests that VXX makes a wobbly and expensive hedge. And it is. But there’s one caveat in VXX’s favor, the one that probably drives the $1 billion daily trading volume in a security with a well-documented and persistent tendency to destroy long-term investor wealth.
The caveat is that the changing correlation theme cuts both ways. I would fully expect VXX to shoot up quickly if a horrible headline sends major equity indexes into the cellar. In other words, it’s likely to achieve perfectly negative correlation just when it’s most needed.
One last note:Correlation is all about direction, not scale. Treasurys will also show strong negative correlation when equity markets tank, but they won’t increase with the same magnitude that VXX will if black swans darken the sky.
Data info:Correlations are based on daily log returns from VXX’s indicative value and SPY’s NAV. Rolling correlation end-dates ranged from May 7, 2012 to May 7, 2013 using data from Bloomberg.
At the time this article was written, the author held no positions in the securities mentioned. Contact Paul Britt at email@example.com .
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