Any investors who are using volatility-linked exchange traded products as long-term portfolio hedges are getting hurt by so-called contango in the CBOE Volatility Index (VIX) futures market.

“VIX futures have been mired in contango for some time, where distant month futures are priced higher than front month futures and thus the ‘roll’ effect when the funds rebalance their futures upon expiration results in damaging losses for the funds tied to the VIX and rebalanced in this fashion,” said contributor Paul Weisbruch at Street One Financial in a recent article. [ETF Chart of the Day: VIX]

Investors need to remember that these products are designed to track VIX futures, not the spot price. [3 Things You Need to Know About VIX ETFs]

Exchange traded products that track volatility have declined sharply along with the VIX. They 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).

“With the huge contango in the VIX futures term structure at the moment, anyone who is buying VIX options or the VIX exchange traded products right now is having to pay for that contango in order to have the opportunity to capitalize on increasing volatility,” according to the VIX and More blog. The contango-based negative roll yield “means the cost of a volatility hedge for long equity positions is extremely expensive in the current market.” The blog recently noted that Barclays ETN+ VEQTOR ETN (NYSEArca: VQT) and iPath S&P 500 Dynamic VIX ETN (NYSEArca: XVZ) “attempt to minimize the impact of the negative roll yield by using a market timing mechanism that dynamically adjusts the long volatility exposure.” [A Unique Volatility-Linked Product]

Volatility-linked ETFs have grown very popular in 2012 with investors scrambling for portfolio hedges. [VIX Touches 5-Year Low]

“The category gained $1.5 billion in February. Total assets in the category grew by 42% last month and now stand at $3.6 billion. Inflows were so strong that VelocityShares Daily 2X VIX Short-Term ETN (TVIX) has suspended new creations,” says Paul Justice, director of North American ETF Research at Morningstar. [TVIX Suspends Issuance]

“What people are missing is that the futures curve for volatility is telling us that, unless the apocalypse really is coming, it will be nearly impossible to make money with these products today. The futures curve is in such an ugly state of contango that, if the volatility index simply stays where it is today, investors can expect to lose nearly 10% every single month,” Justice wrote in the March edition of Morningstar’s ETF Investor newsletter.

“Perhaps this market truly is dominated by speculators betting that volatility will spike soon. But I doubt it. I believe investors are clinging to the experience of 2008 and feel an insatiable urge to protect themselves by using these complex products,” he added.

iPath S&P 500 VIX Short Term Futures ETN

The opinions and forecasts expressed herein are solely those of John Spence, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

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