VIX Drops to Lowest Level Since 2008: Time For A VIX ETF?

by on January 13, 2010 | ETFs Mentioned:

After the unprecedented volatility of 2008 and the dramatic rally of 2009, the market over the past month or so has been quite boring, with indexes trending mostly sideways as stocks look for direction. This has led to greater risk tolerance among investors and has dramatically decreased anticipated volatility for the market. The Chicago Board Options Exchange Volatility Index (better known as the “VIX”), which tracks the anticipated volatility for the S&P 500, recently hit its lowest level in more than a year and a half, falling below 17 in early trading on Monday.

While most asset classes have surged since late 2008, the VIX has plummeted, falling from a high near 80 as anxiety in the markets died down. Unarguably, market participants are much more confident than they were during that turbulent time, it is hard to believe that people are that much more confident in our ability to quickly pull out of the recession and create jobs. Nevertheless, some believe that the VIX has further to go on the downside due to the lack of upcoming market moving events. “There is little in the way of obvious catalysts on the calendar, the risk perception for the next week or so is on the low side” said Scott Fullman, chief derivative-investment strategist at WJB Capital Group.

The historical average for the VIX is just over 20, suggesting that the market is currently anticipating less volatility then average. This is very interesting given the recent market turmoil and dire predictions from several prominent economists. Short-seller James Chanos is forecasting that China will soon crash and could very well be “Dubai times 1,000.” Many predictions for U.S. markets are not much better. The market may be due for a crash thanks to its “sugar high” of government spending and low interest rates, which when taken away could send the economy into a tailspin according to PIMCO chief Mohamed El-Erian.

A return to 2008 volatility may not be imminent, but it is also not an impossibility.

VIX ETF Options

Investors currently have two ways to play volatility, both exchange-traded notes (“ETNs”) from iPath. The two funds, iPath S&P 500 VIX Short-Term Futures ETN (VXX) and iPath S&P 500 VIX Mid-Term Futures ETN (VXZ) are both down significantly over the past 52 weeks (down 70.5% and 30.7% respectively) but may now present an intriguing option for contrarian investors. VXX focuses on short term volatility, investing in futures contracts ending in the next two months, while VXZ tracks an index composed of futures contracts that end in four to seven months.

The funds, especially VXX, have seen a surge in volume as of late, with trading levels reaching four times historical averages for the fund. This could suggest that investors are beginning to bet on a return to volatile markets and that now may be the time to consider taking a closer look at adding volatility to your portfolio. Both funds charge an expense ratio of 0.89% and have a very low correlation to the S&P 500; both hovering around the -0.70 level. This inverse relationship makes these products interesting options for investors looking to hedge domestic equity exposure.

Words Of Caution

While VXX and VXZ represent one of the best ways for investors to insure their portfolios against a market meltdown, it’s important to understand what the underlying assets of these products include. VXX and VXZ don’t invest directly in the VIX (it isn’t possible), but rather on futures contracts on the benchmark.

As any investor in UNG can attest, futures-based investing is a complex process that invites exposure to a number of risk factors. While changes in the VIX will generally have an impact on the volatility ETNs, these products will also be affected by the shape of the futures curve.

And if you thought the contango in natural gas markets was crippling, the market for VIX futures may be terrifying. Recently, January contracts traded at a 10% premium to current levels, while February futures were another 13% above January contracts. For products linked to a benchmark that “rolls” exposure to maintain a short-term focus, this has the potential to erode returns significantly. ETFdb Pro members can read more about volatility ETNs in the ETFdb Category Report (if you’re a Pro member yet, sign up for a free trial or read more here).

A longer-term futures-based strategy avoids some of the potential return erosion from contango, but may suffer from other issues. The impact of changes in the current level of the VIX may be muted on long-dated contracts, meaning that VXZ generally won’t move in lock step with the VIX either. As the chart below shows, while correlation between the three has been strong, the paths of VXX, VXZ, and the spot VIX have diverged quite a bit over the last year.


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Disclosure: No positions at time of writing