Volatility ETFs: How And How Not To Use

by on May 5, 2010 | Updated November 6, 2012 | ETFs Mentioned:

As worries about a potential debt crisis in Europe boiled over on Tuesday, equity markets around the world plummeted in unison. Finding non-leveraged or non-inverse ETFs that didn’t finish yesterday’s session in the red was a challenge; only 14 components of the ETFdb 60 Index finished the day up. But amidst all the carnage, one exchange-traded product stood out, enjoying one of its best days of the year; the iPath S&P 500 VIX Short-Term Futures ETN (VXX) gained more than 10% on Tuesday, rewarding investors who took out an insurance policy against a big uptick in equity market volatility (see Six ETFs To Watch As Greek Drama Unfolds).

VXX’s strong negative correlation with SPY has attracted a fair amount of interest from investors looking to add a diversifying agent to their portfolio. Most investors are familiar with the VIX–a measure of the implied equity market volatility–but some don’t completely understand the risk/return profile offered by an ETN linked to a benchmark comprised entirely of VIX futures. VXX and VXZ (which is linked to the performance of longer-dated futures) are two of the most interesting exchange-traded products out there. But they’re not for everyone [see Free Report: How To Pick The Right ETF Every Time].

How To Use Volatility ETNs

VXX is linked to the S&P 500 VIX Short-Term Futures Index Total Return, an index consisting of first and second month futures contracts on the Chicago Board Options Exchange Volatility Index, better known as the VIX. These contracts offer exposure to equity market volatility, as they generally tend to increase in value when uncertainty creeps into Wall Street. Generally speaking, a low value of the VIX indicates expected stability in stock markets, while a high value indicates expected turmoil. So when news of Greece’s potential fiscal collapse breaks, volatility tends to spike. As such, the VIX generally exhibits a strong negative correlation with equity markets.

Since the end of January 2009 (when the volatility ETN products from iPath began trading), the S&P 500 SPDR (SPY) has lost at least 3% in a single session nine times. During these trading days, the return on VXX ranged from 4.0% to 11.1%, with an average of 6.5%. The reputation of volatility ETFs as insurance against collapses in equity markets is well deserved, so for investors looking to protect against a big slide in prices, VXX is one of the best options available (because VXZ consists of longer-dated contracts, it tends to be far less volatile than VXX).

Better Than Bonds

Bonds have traditionally been embraced as an asset class that provides low correlation with equities, serving to smooth volatility in tumultuous markets. And indeed, bond markets–as measured by the iShares Barclays Aggregate Bond Fund (AGG)–were in positive territory on the nine worst performing days for the S&P 500 since January 2009. But the biggest gain posted by AGG on these days was 0.6%, and the average increase was just 0.4%:

2/10/2009 -4.6% 5.3% 0.6%
3/2/2009 -4.5% 7.1% 0.3%
2/17/2009 -4.3% 5.0% 0.1%
4/20/2009 -4.2% 7.4% 0.6%
3/5/2009 -4.1% 6.0% 0.3%
2/23/2009 -3.6% 5.3% 0.5%
3/30/2009 -3.4% 7.4% 0.5%
2/4/2010 -3.1% 11.1% 0.2%
6/22/2009 -3.0% 4.0% 0.1%

Since VXX’s launch in January 2009, the daily correlation with SPY has been about -0.98. The daily correlation between AGG and SPY during that period? An astounding 0.95 [see Actionable ETF Trading Ideas].

How NOT To Use Volatility ETNs

Similar to automobile or homeowners insurance, there is a cost associated with gaining exposure to volatility. Instead of an explicit monthly premium, the cost of portfolio comes in the form of contango in the VIX futures market. To understand this, it’s important to understand what drives changes in the price of VXX and VXZ. These ETNs don’t measure changes in the “spot” VIX, but rather the change in price of VIX futures contracts. So while VXX will generally move in the same direction as the VIX, that isn’t the only factor that impacts the price of this ETN (as evidenced by the 18% jump in the VIX on Tuesday when VXX rose 10%).

Just like exchange-traded commodity products that use futures to achieve exposure to natural resource prices (see What’s Wrong With UNG?), VXX will be impacted by the slope of the futures curve. If markets are upward sloping, or contangoed, VXX will generally incur a “roll yield” when expiring contracts are sold and longer-dated futures are bought with the proceeds (see VIX ETNs: Crushed By Contango).

Recently, contango in futures markets has been steep, with some contracts trading as much as 15% higher than previous month contracts. That presents some stiff headwinds that VXX must overcome just to break even, and makes holding this fund for the long-term a questionable decision. Based on the turnover figures (about 75 million shares outstanding and average daily volume of 7.5 million), it seems that the holding period for VXX is relatively short (see Five ETFs With Surprising Turnover).

Proceed With Caution

There may be benefits to buying-and-holding VXX for some investors. But in most environments, the odds are overwhelmingly in favor of VXX delivering a negative return over the long haul. That doesn’t mean VXX is a flawed product. Far from it in fact. In a liquidity-driven market where most correlations have shot towards 1.0, VXX is one of the few non-correlated assets left. But when used carelessly, it has the potential to deliver some very undesirable returns.

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Disclosure: No positions at time of writing.