As discussed in my first blog in this series, there is a compelling case for using volatility as a market hedge. While volatility is not an investable asset, investors can access volatility indirectly through futures or options on the CBOE Volatility Index® (VIX). VIX futures, if properly used, may serve as a short-term market hedge.

VIX futures have offered a trailing three-year correlation of -0.841 to the S&P 500 Index and a 0.901 correlation to the spot VIX Index. In weekly environments in which the S&P 500 has negative returns, VIX futures have had a -0.691 correlation, indicating they typically move in the opposite direction of equities. Investors should not, however, expect the same returns as the VIX Index. As demonstrated below, in the worst 10 S&P 500 performances since 2009, VIX futures have generated positive returns but have lagged the VIX index. Over time, this drag has resulted in a difference in performance between VIX and VIX futures.

Historically VIX Futures have lagged the VIX index, but offered strong performance in poor performing equity environments.

What’s behind the performance drag? Roll return

Like any futures contracts, VIX futures returns are derived from three components: spot return, collateral return and roll return.

  1. Spot in this case is represented by the VIX Index.
  2. Collateral return is the return derived from interest generated on collateral posted when entering into a futures contract, typically three-month US Treasury Bills.
  3. Roll return is the return derived from selling a near-term futures contract and buying a longer-dated futures contract. Roll return is likely the most misunderstood return component of futures contracts. As it pertains to VIX futures, roll return has a significant impact on overall returns.

While we believe VIX futures can serve as an effective short-term hedge to market downturns due to its highly negative correlation to the market, a strategic position in VIX futures is neither an efficient long-term market hedge nor a good use of capital, due to roll return. We believe investors should not statically use VIX futures over extended periods of time and expect to effectively hedge their portfolios.

Despite the general negative impact of roll yield, VIX futures have still offered positive performance in poor performing equity environments. We believe this shows, if properly used, VIX futures may serve as an effective market hedge.