VIX ETFs: Crushed By Contango

by on January 20, 2010 | Updated November 6, 2012 | ETFs Mentioned:

The pace of innovation in the ETF industry accelerated in 2009, as issuers introduced countless new spins on the exchange-traded structure that provide investors with more options and more flexibility than ever before. Sector-specific emerging markets and China funds, convertible bond ETFs, and state-specific funds were among the exciting new products to hit the market in 2009. But perhaps the most successful new exchange-traded product launch last year was a pair of volatility ETNs from Barclays, the S&P 500 VIX Short-Term Futures ETN (VXX) and the S&P 500 VIX Mid-Term Futures ETN (VXZ) [see Financials Free ETFdb Portfolio].

VXX and VXZ are designed to provide exposure to equity market volatility through CBOE Volatility Index (VIX) futures. The strategies of these products are similar in most respects, but vary with regard to the underlying holdings: VXX offers exposure to a daily rolling long position in first and second month VIX futures contracts, while VXZ focuses on fourth, fifth, sixth, and seventh month contracts.

Although the VIX was introduced nearly 20 years ago, the ability to invest in the benchmark is a relatively new innovation. Futures contracts on the “fear index” began trading in 2004, and exchange-listed VIX options were introduced in early 2006. The launch of VXX and VXZ in January 2009 democratized VIX investing, bringing this alternative asset class within reach for millions more investors.

Investors may seek exposure to the VIX for a number of reasons, but the strong negative correlation of the index with equity markets is likely the main attraction. “The VIX tracks prices that investors are willing to pay for options on the S&P 500, often to protect themselves against declines,” writes Tennille Tracy. “As a result, the VIX tends to rise when stocks decline and vice versa.”

Indeed, the VIX surged during the most recent recession, gaining nearly 250% between July 2008 and October of that year as expectations for market volatility surged and investors looked to protect themselves against a prolonged period of economic turmoil [For ETF industry news, sign up for the Free ETFdb Newsletter].

The VIX Surged When Equity Markets Plunged

Strong Correlation, But Diverging Results

VIX ETF Correlation
0.95 0.94
VXX     0.96

VXX and VXZ are the most efficient way for most investors to access the VIX, and generally have a strong correlation with movements in the “fear index.” But anyone buying into these ETNs with the expectation of perfect correlation will likely be disappointed. Because VXX and VXZ employ futures-based strategies to achieve their results, day-to-day changes in the underlying benchmark are only one of the factors that impact share prices.

Similar to exchange-traded commodity products like UNG and USO, the shape of the futures curve has had a major impact on the performance of VXX and VXZ. Because there is no way to invest directly in the VIX, the most efficient way for investors looking to hedge against equity market volatility is through options and futures. As shown above, these securities often demonstrate a strong correlation with the VIX. But as demonstrated below, the performance over time can deviate significantly from the underlying benchmark.

In the case of UNG, the frequency with which the fund rolls its holdings was one of the main reasons behind the significant “return lag” of the fund relative to a hypothetical return on the spot price of natural gas (see What’s Wrong With UNG? for a closer look at this issue). The primary headwinds faced by investors in VXX (and to a lesser extent VXZ) is the steep shape of the futures curve for VIX options. Recently, February 2010 futures were trading at a whopping 15% premium to the VIX’s closing value, and March 2010 contracts reflected a nearly 7% premium to February. This becomes an issue for VXX if volatility fails to increase along the futures curve, forcing the linked index to buy contracts that are more expensive than those it recently sold off.

This phenomenon has caused VXX to decline by more than the VIX index over the last year:

VIX ETFs Have Been Unpredictable

Conversely, VXZ has performed much better than the VIX since its inception, thanks to its focus on longer-dated contracts. In general, VXZ will be less volatile than VXX, since day-to-day price movements in the benchmark have more of an impact on near-term expectations for volatility. ETFdb Pro members can read more about VIX ETFs in the ETFdb Category Report (if you’re not a Pro member yet, sign up for a free trial or read more here).

Buyer Beware

The volatility ETNs from Barclays are innovative products, offering exposure to an alternative asset class that would be otherwise inaccessible. For investors concerned about chaotic markets, these ETPs are among the most effective forms of portfolio insurance available. But they’re also very complex, futures-based products that can be difficult to understand. Before jumping in, be sure to do your homework.

Explore VXX on ETFdb:

Disclosure: No positions at time of writing.