One of the most interesting success stories in the ETF industry is that of the United States Natural Gas Fund (UNG). After a moderately successful first 18 months that saw assets climb above $700 million, interest in natural gas as an investment surged in 2009 amidst big drops in prices, political pushes to reduce dependence on foreign oil, and dreams of widespread adoption of natural gas-powered cars. In 2009 cash inflows to UNG totaled nearly $5.6 billion, and fund assets grew by more than 600%. Unfortunately for the investors responsible for this growth, UNG was also one of the worst-performing ETFs of 2009, losing more than half of its value despite little annual change in spot natural gas prices. Although interest in UNG has waned in recent months, it remains one of the largest exchange-traded commodity products and a major holder of natural gas futures contracts (see Six Reasons UNG Is Due For A Comeback).
Another of the most innovative exchange-traded products brought to market in recent years in the iPath S&P 500 VIX Short-Term Futures ETN (VXX), which offers exposure to equity market volatility through futures contracts. While the asset class exposure is very different, VXX is very similar to UNG in several ways; both products have seen waves of cash inflows despite delivering disappointing share price performances.
Since its inception in January 2009, VXX has seen cash inflows of approximately $2 billion, including more than $800 million in the first quarter of 2010. But VXX’s assets at the end of the first quarter totaled just $1.2 billion, the result of a woeful share price performance over the last year and a quarter. Since its launch VXX has lost more than 80% of its value, making it the worst-performing non-leveraged and non-inverse ETF over that period.
The reasons for this less-than-stellar performance are twofold. VXX was launched as volatility measures were receding from all time highs touched during the financial crisis in late 2008. After some initial surges in the first month of trading, markets finally bottomed out and the recovery began. Easing fears of a complete collapse in the financial sector and recoveries in domestic and international markets sent the VIX sharply lower, as triple digit swings in the Dow were replaced by steady gains.
The second factor contributing to VXX’s slide relates to the impact of contangoed markets on a futures-based strategy–a phenomenon with which investors in UNG are all too familiar (see What’s Wrong With UNG?). The index to which VXX is linked consists of first and second month VIX futures contracts, meaning that the underlying holdings must be rolled forward on a regular basis as near-dated contracts approach expiration.
When the futures curve is sloping upwards, this can mean selling relatively cheap contracts to purchase more expensive ones, a negative “roll yield” that can eat into returns very quickly. June VIX futures were recently trading at about $20.40, nearly a 10% premium to May contracts. And the upward slope doesn’t stop there; July contracts cost 17% more than near-month futures (see Three ETFs That Could Be Crippled By Contango).
So it’s important to realize that while the correlation between the value of VXX and the level of the CBOE Volatility Index will generally be very strong, VXX won’t respond perfectly to changes in the spot level of the VIX. Again, a similar lesson could be learned by examining UNG’s performance relative to spot natural gas prices; the “roll yield” has frequently made a greater contribution to total returns than movements in gas prices.
The Big Difference
Despite all the similarities outlined above, these exchange-traded products are very different in the way that they are used by investors. Judging by the implied turnover numbers–about 6 million of the 61 million shares outstanding are traded daily–there aren’t a lot of investors holding the VIX ETN for the long term. And while VXX might not make a wise long-term investment–the contango in futures markets creates some very strong headwinds–it has a lot of use as a more strategic asset.
VXX is an insurance policy against market turmoil, and its performance over the last year has shown that it is an extremely effective insurance policy. In a liquidity-driven environment where correlations between both global equity markets and traditional asset classes have gravitated towards 1.0, locating true diversifying agents is both very important and very challenging.
Since its launch, the correlation between VXX and the S&P 500 SPDR (SPY) has been close to -0.95, statistical support for the inverse relationship between stock prices and equity market volatility of which most investors are well aware. During that same period, the correlation between SPY and the broad-based Barclays Aggregate Bond Fund (AGG) was close to positive 0.95. Bonds may still be safer than stocks, but those counting on them to smooth out volatility may need to reassess their risk profile.
So if you’re looking at VXX’s performance chart and getting concerned, it probably isn’t the right ETF for you anyways. The beauty of VXX lies not in its performance figures but in its correlation coefficient (read more about VIX ETFs).
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Disclosure: No positions at time of writing.