An interesting dynamic shift has occurred in the VIX (CBOE Volatility Index) since the early August equity market meltdown, where the VIX futures curve itself moved from a prolonged period of contango to backwardation.
For years, volatility/VIX related ETFs and ETNs were much maligned in the media and by advisory and institutional firms alike as far as their ability or lack of to track spot VIX themselves. However, if an investor carefully reads the product prospectuses they will note that none of the VIX related ETF/ETN products on the market currently are designed to track spot VIX. This said, utilizing the products effectively as plays on volatility as well as volatility hedges requires not only a comprehensive understanding of how each individual fund is designed, but also a thorough scope of the current VIX futures/market environment in terms of the potential effects of contango or backwardation.
To explain this in layman’s terms, VIX ETFs and ETNs that employ a “roll” strategy, i.e. selling out long futures positions in the front month or some blend of monthly dated futures as the futures come close to expiration to purchase futures further out on the curve in an environment of contango, experience a degradation of returns over time. This occurs because the longer dated futures are priced higher than shorter dated ones by the marketplace (and logically this makes sense, as equity markets are in a stable, uptrending market, investors generally become complacent and are less likely to purchase near term puts in broad based indexes or even VIX futures and options from a portfolio protection standpoint based on recent and historic trends in volatility).
This contango environment in the VIX existed throughout 2009-2010 and most of 2011 until the significant equity market correction beginning this August. At some “point” or points in time, the collective herd of investors began to price near term VIX futures at much higher levels than ones distant on the curve. This makes logical sense as investors tend to scramble in herds to purchase downside protection via single equity puts, broad based index puts, or even get long derivatives such as VIX futures and options in times of market distress (especially sudden and substantial sell-offs) which prompts spot VIX levels much higher, in short order. So, the exact opposite effect that caused long VIX products to “not perform correctly” according to many market observers during times of contango, is currently occurring in the marketplace to the benefit of these long VIX products and investors get the benefit of the “roll yield,” as front and near month VIX futures are closed out at profits to purchase longer dated VIX futures that are priced more inexpensively, locking in gains.
To get some scope of the move itself in the VIX, the index itself traded as low as $15.12 in mid June only to surge to $48.00 during the sweeping downdraft of the initial wave of selling in the August equity market correction. Since that peak, the VIX has traded between 30 and the mid 40s, with a low level of 30.16 and closing at 42.96 on Friday. Interestingly, despite the continued equity market distress, and with the VIX “off” of it’s recent high of 48.00, related “long VIX” ETFs and ETNs are actually registering new highs currently. The same vocal critics of these VIX products in an environment of contango have been notably silent in recent months as the dynamics of VIX and the market itself have markedly changed. The current backwardation effect of the VIX futures curve actually contributes to returns that are generated by VIX related, “long” ETFs and ETNs, whereas the contango eroded returns over time in such positions. On the flipside, short positions in “long” VIX related products or long positions in inverse VIX products are penalized now due to the inherent structure of the funds and how it relates to the VIX futures curve.
One can simply refer to recent price performance charts in long VIX related funds such as iPath S&P 500 VIX Short-Term Futures ETN (NYSEArca: VXX), VelocityShares Daily 2x VIX Short-Term ETN (NYSEArca: TVIX), iPath S&P 500 VIX Mid-Term Futures ETN (NYSEArca: VXZ), ProShares VIX Short-Term Futures (NYSEArca: VIXY), VelocityShares VIX Short-Term ETN (NYSEArca: VIIX), C-Tracks Citi Volatility ETN (NYSEArca: CVOL) and Daily 2X VIX Medium-Term ETN (NYSEArca: TVIZ) and see that new recent price highs are occurring despite the fact that the VIX itself is off of the early August highs. Conversely, short related VIX funds such as XIV and XXV are trading at recent lows as the backwardation effect of the VIX futures market is currently eroding returns there.
VIX related ETFs and ETNs have been an area of incredible growth in terms of increased trading volumes and asset inflows in the past few quarters, and product innovation in the space is evident as well as a number of issuers are now involved in the space. For time, only iPath was active in the volatility arena, but now VelocityShares, ProShares, UBS, and even Citi have registered products in the category. However, it is more important than ever for investors, advisory firms, and institutions alike to recognize that these products generally differ in their index construction, and they can be used effectively as directional trading and hedging tools if employed properly and not simply viewed as direct plays on the VIX index itself, which they are simply not.
Christian Wagner, Chief Investment Officer of Longview Capital Management (http://www.longviewcptl.com/) based in Wilmington, DE and advisor to the Longview Global Allocation Fund (a mutual fund under ticker: LONGX) clearly believes that VIX related ETFs and ETNs are simply not for everyone, which would likely remove a large amount of the negativity and misunderstanding that has pervaded the funds in recent years. Wagner, whom utilizes volatility based ETPs in his portfolios in a volatility based strategy states:
“Unfortunately one of the most innovative and effective hedging tools developed in recent years is also one of the most misunderstood and therefore misapplied. Investors need to grasp the fact that the VIX quote on their television screen bears little resemblance to the VXX ETN quote that appears on their trading screen. Unlike the S&P500 Index ( SPX) and the S&P 500 SPDR ETF (SPY) the VIX Index and the iPATH SP500 VIX ETN (VXX) share no similar consistent correlation. The underlying volatility index calculations and ETN components are vastly different. In times of heightened volatility these differences are multiplied. Unless the investor has a true understanding of these variances and their possible consequences they should avoid self sacrifice.”
We hope that education and understanding of what these volatility based products are designed to do, and where and when they may be most appropriate to utilize in portfolios or trading strategies will become the emphasis of the next round of scrutiny of the products instead of blind negativity based on embedded misconceptions and the lack of paying attention to detail and ever changing underlying market dynamics. The fact that none of these products are designed to track spot VIX itself in lockstep and have inherent limitations and imperfections, presents both challenges and opportunities to the ultimate end user.
This said, the products are likely not a fit for everyone, but can add value to one’s investment trading strategy or hedging strategy if employed and re-balanced properly and intelligently.
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