Guide To Volatility ETFs: Volatility ETN Investing 101

by on October 26, 2009 | ETFs Mentioned:

Every investor has a few benchmarks that he or she watches closely to keep a pulse on the market. The S&P 500 and Dow Jones Industrial Average are perhaps the most widely-followed benchmarks in the U.S., recognized by just about everyone. The CBOE Volatility Index (better known as the VIX) doesn’t have nearly the level of recognition, but it is an extremely important benchmark for investors concerned about where the markets are going, not necessarily where they’ve been.

CBOT Trading FloorThe VIX is a measure the implied volatility of S&P 500 Index options. The index represents the market’s expectation for volatility over the next 30 days. Since its inception in the early 1990s, the VIX has generally ranged between 15 and 30. At the end of 2008, however, it surged to more than 80, as daily gains and losses of 2% or more became fairly commonplace in the U.S. equity markets.

Investing In The VIX

In March 2004, futures on the VIX were introduced, making it possible for certain investors to speculate on or hedge against changes in implied volatility. In early 2009, investing in the VIX index became even easier with the introduction of two exchange-traded notes linked to indexes composed of futures on the VIX: the iPath S&P 500 VIX Short-Term Futures ETN (VXX) and Mid-Term Futures ETN (VXZ).

These products have proved to be very popular among investors – since their inception in late January, they have seen cash inflows of more than $800 million. Some of the investors in VXX and VXZ are no doubt speculators looking to turn a quick profit on a jump in volatility. But others have found use for these ETNs as a sort of “portfolio insurance.”

During the recent recession, many investors complained that diversification let them down just when they needed it the most. Global equity markets tumbled simultaneously, as did real estate investments around the globe. But an investment in the VIX proved to be an effective strategic diversifier. The S&P 500 lost about 40% between August 2008 and November 2008, a period during which the VIX gained nearly 300%.

Under The Hood

VXX and VXZ don’t track the VIX directly. The index to which VXX is linked maintains a daily rolling long position in the first and second month VIX futures contracts, while VXZ tracks a basket consisting of fourth, fifth, sixth, and seventh month VIX futures. The structure of these products is similar to commodity funds that invest in futures contracts instead of buying and holding the relevant natural resources directly.

So investors who expect these ETNs to track the VIX exactly will more than likely be disappointed. While there is a strong correlation between the price of these securities and the VIX, it isn’t a perfect one. Since the inception of these notes, implied and expected volatility has plummeted as hopes for a more stable environment have taken root. As shown below, VXZ hasn’t been nearly as volatile as the VIX index, while VXX has actually declined more than the index.

VIX vs. VIX ETFs

Generally, VIX futures with a longer time until maturity trade at a higher price than those with a shorter time until maturity. This has been the primary reason for the difference in performance between VXX and VXZ this year. Current volatility (and expectations for short-term volatility) has fallen more sharply than expectations for volatility in coming months. As such, the price of VXZ has held up better in recent months. Presumably, if we were to see a big uptick in volatility, VXX would rise by a greater percentage than VXZ. In other words, of the two major volatility ETNs, VXX is the more volatile.

Prices of VIX futures as of October 23 were:

VIX Futures Prices

For investors looking to add some portfolio protection against a double dip, VXX and VXZ are two of the best options available. But before you get into either of these volatility ETNs, make sure you know exactly what you’re buying. And for more actionable ETF investment ideas, be sure to sign up for our free ETF newsletter.

Disclosure: No positions at time of writing.