As the broader market reaches new highs, the CBOE Volatility Index, or “VIX,” is dipping toward a seven-year low. While investors can utilize VIX-related exchange traded funds to hedge market swings, the so-called father of the VIX warns that traders need to understand how they work.
The iPath S&P 500 VIX Short-Term Futures ETN (VXX) , the largest volatility-based exchange traded note that tries to track VIX index movements, fell 4.8% Friday. VXX is down 24.9% year-to-date.
The CBOE Volatility Index was hovering around 11.1 at last check Friday after dipping below the 11 level, the first time since early 2007. Historically, the VIX has averaged about 15 to 20. The volatility index is a gauge of implied volatility on S&P 500 index options. Essentially, the VIX strengthens when volatility increases or when equities begin tanking. [VIX ETFs Reveal a Complacent Market]
“But there is a major drawback to these products that many investors might be missing,” writes Robert Whaley, professor at Vanderbilt University and developer of the CBOE Market Volatility Index, for CNBC. “The most popular VIX ETPs are not suitable for buy-and-hold investors because they are virtually guaranteed to lose money over time.”
Since most traders don’t access the futures market, VIX exchange traded products provided a convenient alternative to gain exposure to the VIX contracts. In 2013, IVX futures trading volume touched a record high for the fourth year in a row. In 2014, average daily trading volume also set a fourth-straight annual record.
However, investors need to realize that VIX ETPs track futures contracts and not the spot VIX. Since they track futures contracts, the funds can lose money in the so-called contango trap where the futures price curve slopes upward – ETPs could lose money when selling near-month contracts that are about to mature for costlier later-dated contracts, essentially selling low and buying high every time they roll futures contracts. [Backwardation & Contango]
“My research found that the price curve sloped upwards on nearly 80 percent of all trading days for futures with 30-day maturities,” professor Whaley said. “This erosion happens because the price of longer-dated futures contracts is almost always higher than the price of shorter-dated futures contracts.”
Consequently, professor Whaley suggests investors to stick to mid-term VIX exposure to help limit losses due to contango, but potential short-term gains are also diminished. The professor also suggests ticking to funds that track Total Return indices, like VXX. Furthermore, he advises investors to keep an eye on new, more efficient VIX products that reduce expenses and negative roll problems. [Father of VIX Options Enters ETF World with AccuShares]
iPath S&P 500 VIX Short-Term Futures ETN
For more information on the CBOE Volatility Index, visit our VIX category.