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VIX ETFs: An Imperfect Hedge


Volatility exchange traded products such as iPath S&P 500 VIX Short-Term Futures ETN (VXX) have seen inflows and increased trading volume during this week’s stock pullback.

Some traders use these products to hedge long portfolios or even speculate on equity sell-offs.

However, investors need to keep in mind that these ETFs are designed to track CBOE Volatility Index futures contracts, not the VIX spot price. It’s a very important difference.

VXX was up for the second straight day on Thursday, gaining about 11% from Tuesday’s close. However, spot VIX was up about 23% from Tuesday’s close in early trading Thursday. [Dow 14,000: The Death of Volatility ETFs?]

Other volatility ETFs include VelocityShares VIX Short-Term ETN (VIIX), VelocityShares Daily 2x VIX Short-Term ETN (TVIX), ProShares Ultra VIX Short-Term Futures (UVXY) and ProShares VIX Short-Term Futures ETF (VIXY). Some of the products provide leverage on a daily basis.

Adam Warner at Schaeffer’s Investment Research cautions against using volatility-linked products to try to catch the bottom in VIX.

“You can’t actually buy the VIX,” he writes. Instead, traders can purchase the volatility ETFs that are based on VIX futures. [VIX ETFs: Beware Contango]

The problem is that longer-dated VIX futures contracts are progressively expensive.

[I]f you want more time for that VIX rally you’re sure is going to happen, you’re going to have to pay more and more premium. Go out three months, for example, and that VIX ‘bottom’ you bought is four points above the actual VIX,” Warner notes.

“Another way to look at this is that everybody ‘knows’ the VIX is going to rally, and the market is already pricing that in,” he adds. “Yes, the whole complex will lift if the VIX moves significantly higher. But the gains in a tradable VIX product will severely lag gains in the VIX itself.”

Volatility products are designed to “roll” the contracts over periodically to maintain exposure to VIX futures. They can lose money on this trade when longer-dated contracts are more expensive than the front-month contract, or when markets are said to be in “contango.” [Double Whammy for Volatility ETFs]

VXX, which is an exchange traded note, is down nearly 80% for the trailing 12 months.

“This ETN is designed for use as a tactical trading tool, with prospective holding periods to be measured in days, not weeks,” writes Morningstar analyst John Gabriel in a profile of VXX.

“This is because holding this ETN exposes investors to excessive drag on their portfolios due to the sharp negative roll yield related to rolling futures as they near expiry,” Gabriel points out. “In 2012 when the spot VIX fell 23%, this ETN’s net asset value plunged more than 78%. And in 2011, despite the fact that the spot VIX rose 32%, this ETN’s NAV fell about 5%. A buy-and-hold investor could have had the right idea but would have been burned by contango regardless.”

iPath S&P 500 VIX Short-Term Futures ETN


The opinions and forecasts expressed herein are solely those of John Spence, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.