Volatility ETFs Continue Freefall: Time To Buy?

by on October 13, 2009 | ETFs Mentioned:

The Chicago Board Options Exchange Volatility Index, better known as the VIX, has been one of the most carefully-watched benchmarks since its inception in the early 1990s. In 2004, VIX futures gave investors a way to actually invest in the benchmark, as did VIX options in 2006 (both won the Most Innovative Product award at the Super Bowl of Indexing Conference). Earlier this year, investing in volatility became a whole lot easier for the “average” investor with the introduction of a pair of exchange-traded products from iPath: the S&P 500 VIX Short-Term Futures ETN (VXX) and the S&P 500 VIX Mid-Term Futures ETN (VXZ).

Chicago Board of TradeVIX 101

Simply put, the VIX measures the market’s expectation of volatility over the next 30-day period. More specifically, the index represents the implied volatility of S&P 500 index options, with its value roughly translating to the expected annualized change over the next month. If the VIX is at 20, the expected annualized change in the S&P over the next 30 days is about 20%.

The VIX is sometimes known as the “fear index,” but a high VIX measurement isn’t necessarily an indication of a bear market. The VIX is a measure of volatility in either direction, including to the upside.

Historical VIX Pricing

Since its inception, the VIX has been, well, volatile. Its spikes have generally coincided with periods of economic uncertainty – the VIX reached historically high levels in late 2002 and early 2003 as market turmoil reigned.

But those run-ups were nothing compared to the events of 2008. Between May and November of that year, the VIX increased nearly fourfold as chaos gripped the equity markets and triple-digit swings in the Dow became a near-daily occurrence. Since peaking in November 2008, the VIX has gradually retreated, approaching more reasonable levels.

A significant portion of these losses have come in the last seven trading sessions, each of which has seen a further slide in the “fear index.” But even after losing 75% since its peak in November 2008, the VIX still remains about 15% above its long-term historical average (and 20% above its long-term average prior to May 2008). Still, given the fragile nature of the economic recovery, the potential for surprises in the upcoming earnings season, and less predictable Fed behavior in coming quarters, investments in VIX futures are becoming an interesting option.

The VIX is Approaching Its Long-Term Average

The two volatility ETFs offered by iPath differ slightly in the exposure they offer. VXX reflects the return of a daily rolling long position in first and second month VIX futures contracts, while VXZ reflects the return in a position in the fourth, fifth, sixth, and seventh month futures contract. It may sound minor, but this nuance has a major impact on returns. Since inception in January, VXX has dropped about 56% while VXZ has declined only 22%. According to the iPath Web site, the correlation between the VIX and VXX is about 0.71, while the correlation between the VIX and VXZ is 0.66.

Not Just For Speculators

While the vast majority of interest in products tied to the VIX is likely short-term and speculative in nature, these products can provide excellent diversification benefits when added to long-term portfolios. Many investors have lamented that international diversification let them down just when they needed it most, as global equity markets crumbled in unison over the last two years. The VIX, on the other hand, has provided the benefits of diversification just when investors needed it the most.

Since 1990, the correlation between the S&P 500 and the VIX has been a relatively weak 0.14. But since the beginning of 2008, the correlation between the VIX and the S&P has been -0.69, indicating a remarkably strong inverse relationship during uncertain economic times. By comparison, the correlation between domestic and emerging markets (as measured by SPY and EEM) has been above 0.90 during that period and the relationship between domestic equities and bonds (as measured by AGG) has been close to zero.

AGG -0.04
VNQ 0.81 -0.17
EEM 0.91 -0.09 0.73

Many investors are now considering allocating a small portion of their cash holdings to volatility exposure, thereby implementing an effective hedge against future market volatility while still maintaining some potential for profitability if future volatility is tilted towards the upside. For more actionable investment ideas, be sure to sign up for our Free ETF Newsletter.

Disclosure: No positions at time of writing.