Volatility ETFs are facing a war on two fronts in a declining CBOE Volatility Index combined with the steepest VIX futures curve since the financial crisis.
The spot VIX that investors see quoted in the news as Wall Street’s “fear gauge” has fallen to the lowest level in five years. [‘Most Hated Rally’ Lifts Stock ETFs for Sixth Week]
A falling VIX has weighed on volatility-linked ETFs. These exchange traded products include iPath S&P 500 VIX Short Term Futures ETN (NYSEArca: VXX), ProShares Ultra VIX Short Term Futures ETF (NYSEArca: UVXY) and VelocityShares Daily 2X VIX Short Term ETN (NYSEArca: TVIX).
The products track VIX futures contracts, not the spot price, which is a crucial difference that investors shouldn’t overlook.
Crushed by contango
The products are designed to “roll” the contracts over periodically to maintain exposure to VIX futures. They can lose money on this trade when longer-dated contracts are more expensive than the front-month contract, or when markets are said to be in “contango.” [VIX ETFs: Beware Contango]
“While the ultra-low VIX may be reflecting a calm stock market, futures on the VIX show investors fear there increasingly could be trouble brewing down the road,” CNBC.com reports. “The VIX futures curve is at the steepest level since before the financial crisis began, with each progressing month at a higher and higher level with longer term volatility at a much higher premium than short-term volatility.”
In other words, investors think volatility will pick up the next few months. The steep VIX futures curve also means volatility funds will lose more on the roll trade.
Piling into volatility ETFs
Investors looking for insurance against market pullbacks have pumped a lot of money into volatility ETFs in recent months. [Volatility ETFs Gather Heavy Inflows Despite VIX Decline]
The products have grown so large that they may be impacting spot VIX and futures prices.
One reason the August VIX futures are depressed compared to later months is because VXX is still rolling into the September contract form the August contract, said Jordan Beck of BTIG, in the CNBC report.
“That puts extra pressure on the August futures,” he said. The August contract expires Wednesday.
The spot VIX was trading at 14.17 on Friday, according to CBOE.com. The September VIX futures were trading hands at 18.75, or a premium of about 32%.
Is spot VIX telling the truth?
According to the CBOE’s definition, the VIX is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices.
Some are interpreting a VIX hovering around 14 as a sign of complacency, The Wall Street Journal reports. “But a low VIX doesn’t mean that traders have stopped buying protection or are overly confident in price increases. It just means the price of puts and calls—options that profit from falling and rising prices, respectively—is low,” the newspaper said.
A recent Barron’s report explained the difference between spot VIX and derivatives based on the index.
“Everyone talks about spot VIX…but VIX futures tell the real story. VIX futures, compared with spot VIX, are extremely expensive, even though it is common to hear people say the VIX is so low that it indicates investors are complacent and perhaps suggests a short-term market correction is imminent,” Lawrence McMillan wrote for Barron’s.
He points out it’s impossible to trade the spot VIX that investors see quoted. Traders paying far in excess of spot VIX levels for VIX futures that expire in coming months is further evidence that the stock market rally has few believers, he added.
Much of this VIX futures buying is a direct result of the heavy demand for VIX exchange traded notes, primarily VXX, McMillan said.
“Heavy investor demand for VXX creates heavy demand for VIX futures. This, in turn, sharply boosts VIX future prices, telegraphing another contrary indicator,” he wrote. “When the investing and trading public start believing in this rally, the put-call ratios will start to reverse and the term structure of the VIX futures will flatten. Only then will it be time to sell stocks. Until then, the market—hated as it may be—can continue to march upward against this tide of negativity.”
iPath S&P 500 VIX Short Term Futures ETN
Full disclosure: Tom Lydon’s clients own TVIX.