Innovation not only in the ETF space but throughout the financial industry has opened up new opportunities in recent years, allowing investors to access asset classes and strategies that had previously been out of reach. One example of such a phenomenon is the volatility space, which has been transformed from a hypothetical but widely-followed measure of investor sentiment to an investable asset. The VIX, which measures the implied volatility of U.S. equity markets over the next 30 days and is computed using inputs from S&P 500 options, has been around for more than two decades, but by the vary nature of its calculation is not an investable asset [see How ETFs Have Democratized Investing].
Thanks to the introduction of options and futures linked to the VIX over the last several years, this measure of volatility has been transformed into (essentially) an investable asset class. And the more recent development of exchange-traded products that invest in VIX futures has made volatility readily available within any investor portfolio.
Gaining exposure to the VIX is tremendously appealing to some investors thanks to the strong negative correlation between the “fear index” and global equity markets. Traditional concepts of diversification, such as spreading exposure across various geographies, have had shortcomings exposed by the sharp downturns of recent years: many forms of diversification have a bad tendency of letting investors down when they need it the most [see Using ETFs As Portfolio Insurance].
While exposure to the VIX has appeal, it’s important to note that exposure to the spot VIX still isn’t possible; as mentioned above, the value of this index is derived not from prices of component securities but from the prices of options on equity indexes. So the ETPs found in the Volatility ETFdb Category actually invest in VIX futures (on, in the case of ETNs, are linked to indexes comprised of VIX futures). This feature is necessary to make exposure possible, and it means that performance of these products depends on factors beyond the performance of the spot VIX–including the slope of the VIX futures curve.
The events of the last week–including steep equity market declines in the wake of the Japanese earthquake and ongoing tensions in the Middle East–presented an opportunity to analyze how the nuances of a futures-based strategy and other features of VIX ETPs translate into bottom line performance.
Last Wednesday was a dismal session for equities, with the S&P 500 SPDR (SPY) dropping close to 2% on the day as worries about a full-blown nuclear crisis in Japan intensified. Not surprisingly, as anxiety about global equity markets spiked so too did the VIX; the “fear index” was up more than 20% on the day. Many volatility products also saw big swings during that session; below, we take a look at how many of the exchange-traded volatility products performed as the VIX was skyrocketing [for more ETF insights, sign up for our free ETF newsletter].
One way of bifurcating VIX products involves segmenting by the duration of the underlying futures products into short-term and mid-term. Short term products, such as VIXY and VXX, generally offer exposure to a position in first and second month VIX futures. Mid term products, such as VIXM and VXZ, will offer exposure to fourth month contracts through seventh month contracts. There are pros and cons to each type of product. Short-term exposure will generally exhibit higher correlation to changes in the spot VIX. But because contango is often steepest at the short end of the maturity curve, the adverse impact of an upward-sloping curve may be more severe.
On the day the VIX jumped 21%, the ProShares VIX Short-Term Futures ETF (VIXY) surged about 9%–a huge gain but a jump considerably smaller than the movement in the spot VIX. Again, that disconnect reflects not a flaw in the exchange-traded product, but the difference in the risk/return profile of the VIX compared to an index comprised of VIX futures.
The mid-term counterpart to VIXY, the VIX Mid-Term Futures ETF (VIXM) climbed about 3% during Wednesday’s session. That move reflected expectations for the level of the VIX several months down the road. As such, VIXM tends to exhibit less volatility than VIXY or the spot VIX.
Leveraged VIX ETPs
Innovation in the Volatility ETFdb Category has given investors options for amplifying exposure to VIX-based indexes. Two products from VelocityShares, again split by duration of the underlying futures contract, provide 2x exposure on a daily basis. Similar to many leveraged products offering exposure to equities or other asset classes, the Daily 2x VIX Short Term ETN (TVIX) and Daily 2x VIX Mid Term ETN (TVIZ) reset on a daily basis, meaning that the impact of compounding can come in to play over holdings periods less than or greater than a single session [see Leveraged ETF Center].
TVIX jumped about 17% during Wednesday’s session–about what could be expected given the change in the S&P 500 VIX Short-Term Futures Index. It’s interesting to note that the impressive one day performance of the 2x leveraged product was still less than the change in the spot VIX, reflecting the significant differences between these two measures of volatility even over a single trading session.
Inverse VIX ETPs
Inverse volatility ETPs are another new innovation in the space, and the VelocityShares Daily Inverse VIX Short-Term ETN (XIV) has become popular as a way to exploit the steep contango that is often present at the short end of the VIX futures curve. Again, this product doesn’t seek to deliver results that correspond to the inverse of the spot VIX, but rather to the inverse of an index comprised of short term VIX futures contracts.
Contango often presents stiff headwinds to investors in products such as VXX or VIXY, and XIV is essentially designed to exploit the very factors that erode performance in those ETPs. By essentially allowing investors to put the winds of contango at their backs, XIV has the potential to deliver positive returns not only when the VIX is down (as it did in December) but also when the VIX rises. XIV added 15% during January when the spot VIX was actually up 10% [see XIV: Free Money?].
There are, of course, risks to funds like XIV, and the recent spike of the VIX serves as an excellent illustration. XIV sank 8% in Wednesday’s sessions–a much smaller decline than the change in the spot VIX but a big loss nevertheless. Because XIV reset’s exposure on a daily basis, it is also subject to the nuances of compounding returns–which include a smaller asset base off of which any subsequent gains would be incurred.
Long/Short VIX ETN
Another of the creative combinations of the exchange-traded structure and volatility is the UBS E-TRACS Daily Long-Short VIX ETN (XVIX), a product designed to exploit the steepness on the short end of the VIX futures curve. XVIX is linked to an index that maintains a 100% long position in the S&P 500 VIX Mid-Term Futures Index Excess Return with a short 50% position in the S&P 500 VIX Short-Term Futures Index Excess Return. The result is a product that offers non-correlated exposure but hedges out exposure to the short-term index, making it a potentially interesting for investors looking to achieve exposure to volatility over a longer time period.
During Wednesday’s session, XVIX lost about 1%, a result to be expected then the gain on the short-term futures index was more than twice as large as the change in the mid-term index.
Longer Time Period
Wednesday capped off a three-session stretch that saw the VIX jump a whopping 46% and SPY sink by about 3.6%. A look at the performance of the various products highlighted above during that longer period demonstrates how the nuances of daily compounding can impact certain strategies.
Again, the jump realized by products such as VIXY and VIXM paled in comparison to the change in the spot VIX, which dwarfed even the gains in leveraged products. Investors in XIV were certainly happy to maintain shot exposure to a futures-based index as opposed to the spot VIX; the inverse product lost about 13% during the three-day run, an absolute return less than a third of the change in the spot VIX over that period [see Breaking Down The VIX ETF Options].
While the tables and examples above may be helpful for understanding how the complex features of VIX products translate into live performance, it should be noted that the relationships between the various products are by no means static. The degree of contango or backwardation in futures markets, which is constantly shifting, plays a major role in determining the sensitivity of all of these products relative to the spot VIX.
When it comes to the leveraged and inverse products, the direction of markets is a major variable as well. During the three day stretch highlighted above, the VIX steadily increased and equities steadily declined. In oscillating markets, where gains are followed by losses and vice versa, the daily reset of these products can have some interesting effects on bottom line returns.
Disclosure: No positions at time of writing.