Tagged as the ‘Investor Fear Gauge’, the CBOE Volatility index or ‘VIX’ has become one of the most popular market barometers across the globe. Unlike other indexes which measure the performance or health of a particular asset class such as equities, bonds and currencies, the CBOE VIX measures the expected volatility that the equity market (i.e. S&P 500) is going to witness in the next 30 days.
To be more technical, the VIX is computed using the implied volatility over the next 30 days of S&P 500 index options with varying strike prices, and VIX is simply the average of these implied volatilities (see 4 Low-Volatility ETFs to Hedge Your Portfolio).
However, the VIX was initially based on only eight at the money (i.e. strike price equal to the underlying value) options of the S&P 100 Index (:OEX). However, now it encompasses a more holistic and comprehensive approach of computation using options across various strike prices from the S&P 500 Index options.
With this and many other developments in the financial world, new exchange traded products targeting the VIX have been launched (read Zacks Top Ranked Financial ETF: Star in Q3 Earnings). However, there are lots of myths surrounding them and most often investors get burned by these potent products.
Therefore, investing in these highly complex products requires a great deal of knowledge about their workings. This article seeks to highlight three facts that investors should consider before investing in any volatility ETF:
Long VIX ETPs are subject to Contango
Volatility ETPs which provide a long position in the VIX are subject to contango effect arising from the volatility forward curve. Most of these products use the VIX futures in order to replicate the rise/fall in the VIX since investing directly in the VIX is not possible.
Under normal circumstances in the VIX market, the futures curve is upward sloping which symbolizes that the futures price is greater than the spot price. As a market mechanism, on expiry, the futures and spot prices converge.
This happens in two ways as expiry approaches 1) The spot price rising towards the futures price, OR 2) The futures price falls in order to converge to the spot price (read Natural Gas ETFs: Futures vs. Equities).
A great example of this phenomenon is the most popular VIX product out there, the iPath S&P 500 VIX Short Term Futures ETN (VXX). This ETN, which seeks to generate returns equivalent to the daily rolling long position in the immediately first and second month VIX futures contracts, has been a victim of contango which has greatly eaten into the fund’s returns.
VXX has seen heavy contango in the recent past because the VIX forward curve has been upward sloping, and the positive market sentiments have caused the VIX (i.e. Spot) to fall.
Thus, the futures price has been declining to converge to the spot price at or near the expiry mainly thanks to the positive market sentiments. This has led to dismal performance of the ETN. On a one year basis, VXX has lost around 83% as of 30th September 2012.
Medium Term VIX ETPs face less contango than Short Term Ones
Compared to the short term focused VXX, its medium term counterpart iPath S&P 500 VIX Medium Term Futures ETN (VXZ) has been a better performer, although both have slumped significantly due to the contango effect.
Instead of providing a daily roll over position in the first and second month of VIX futures, the ETN targets the intermediate part of the volatility forward curve and smoothens out its positions on a daily roll over basis in the fourth, fifth, sixth and seventh month (read Uncertain about the Economy? Try Market Neutral ETFs).
This significantly reduces the contango effect as the far month contracts relatively lose less value than the front month ones. On a one year basis, VXZ has returned -53.73% compared to the short term focused VXX returning -83% for the same time period.
Also confirming this fact is the lower aggressiveness of the medium term focused volatility ETPs than the short term focused ones is its beta value against the VIX itself. As we can see from Table 1, the Medium term focused ETPs like VXZ and VIXM have beta values of 0.23 and 0.24 respectively versus the VIX indicating less vulnerability.
Two other ETPs from ProShares fund family also highlight this fact. The ProShares VIX Mid-Term Futures ETF (VIXM) and the ProShares VIX Short-Term Futures ETF (VIXY) are very similar in terms of investment objective and strategy to their iPath counterparts VXZ and VXX. Even in case of the ProShares VIX ETPs, the story has been the same.
Both funds launched in April of 2011, and have witnessed heavy contango over the recent past. Nonetheless, to highlight our point, it is noteworthy that the short term focused VIXY has lost 73.21% in fiscal 2012, compared to the medium term focused VIXM losing around 43% for the same time period (data as of September 30th 2012).
VIX ETPs rise/fall more than the fall/rise in the S&P 500
As of now it must be fairly clear that the Volatility Index and the S&P 500 move in opposite directions. However, the magnitude of the inverse proportionality varies significantly.
It has been observed that the over the past three years, the VIX has had an annualized standard deviation (i.e. a measure of realized/historical volatility) of 119.90% compared to the annualized standard deviation of 18.64% for the S&P 500 for the same time period (see more in the Zacks ETF Center).
Thus it becomes prudent for the exchange traded products to follow their benchmark (i.e. VIX) and rise or fall more than the fall/rise in the S&P 500. This characteristic of VIX ETFs is more profound in the short term focused ones than the medium term ones.
The table below (Table 1) suggests that the short term ETPs i.e. VXX and VIXY have beta values of nearly -3 against the S&P 500, which is double the beta value for their medium term counterparts which is around -1.50. Nevertheless, all these products have strong negative beta values (i.e. less than -1). This suggests that VIX ETPs are more responsive to the changes in the S&P 500 (see IndexIQ Launches New Market Neutral ETF).
In fact, in the first 3 quarters of fiscal year 2012, VXX and VXZ have lost around 73% and 43% respectively, however, at the same time period the S&P 500 has generated positive returns of around 12.81%.
Correlation (with VIX)
Beta (with VIX)
Correlation (with S&P 500)
Beta (with S&P 500)
(Data as of September 30th 2012)
Hopefully, now that you know these key factors, you can trade volatility ETPs more effectively. These products are probably not suited for long term investors—as seen by the performance in 2012—but they could make for great hedges during uncertain market times, like the one we find ourselves in now, assuming of course you have a high risk tolerance as the ‘volatility of volatility’ can be quite high.
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Read the analyst report on VIXY
Read the analyst report on VXX, VXZ, VIXM, VIXY