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
30
th
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%
.
Table 1
|
ETF
|
VXX
|
VXZ
|
VIXM
|
VIXY
|
|
Term
|
Short Term
|
Medium Term
|
Medium Term
|
Short Term
|
|
Correlation (with VIX)
|
88.81%
|
83.45%
|
83.48%
|
88.94%
|
|
Beta (with VIX)
|
0.48
|
0.23
|
0.24
|
0.51
|
|
Correlation (with S&P 500)
|
-84.44%
|
-82.45%
|
-81.23%
|
-82.79%
|
|
Beta (with S&P 500)
|
-2.97
|
-1.45
|
-1.47
|
-3.03
|
(Data as of September 30
th
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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PRO-VIX MT FUT (VIXM): ETF Research Reports
PRO-VIX ST FUT (VIXY): ETF Research Reports
IPATH-SP5 VX ST (VXX): ETF Research Reports
IPATH-SP5 VX MT (VXZ): ETF Research Reports
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