Note: This article is part of the ETF Trends Strategist Channel
By Marc Odo
Synopsis: If one wishes to profit from market volatility, it is unfortunately much easier said than done. It is especially very difficult to capitalize on market volatility using volatility ETPs for the following reasons:
- By using futures on VIX, most volatility ETPs are subject to massive downward price pressure due to contango
- Passively managed volatility ETPs are not designed to react to changing market conditions
- Variance drain is quite detrimental to long-term returns
Although the S&P 500 was up a modest 3.84% in the first half of the year, it’s been a bit of a wild ride. The first quarter of 2016 was the first time since 1933 that the market had a sell off of double-digits and yet still finished in the black at quarter-end. The second quarter will be remembered for the wild market gyrations following the “Brexit” vote. With numerous significant events looming on the calendar, there’s likely just one thing that bulls and bears can agree upon: it’s going to be volatile.
So the shrewd investor might try to capitalize on the increased market volatility. Indeed, some investors treat “volatility” as a distinct asset class. There are close to two dozen ETPs in the Morningstar database that attempt to capitalize on volatility in some shape or form, up from zero in 2009. This category includes long volatility and short volatility strategies, leveraged and unleveraged, ETNs and ETFs, and has an aggregate AUM of around $4.5 billion. They are used as hedging vehicles as well as speculative plays.
While betting on volatility might seem like a bright idea, the unfortunate reality is the long-term performance of volatility-based ETPs has been atrocious. The average return in the volatility category over the first six months of 2016 has been -17.63%. Over the last three years the averages have been -23.87% (2015), -20.50% (2014) and -21.30% (2013). Why is this?
A lot of the problem stems from the fact that most of these products are based on VIX futures, or futures on the CBOE Volatility Index. But just what exactly is the VIX? A lot of people commonly refer to the VIX as the “fear gauge” but that description leaves a lot to be desired. What is VIX actually measuring? How is it calculated?
When you get down to it, the VIX is calculated by inferring the implied volatility of the S&P 500, using the prices of a basket of puts and calls on the S&P 500 as an indicator of market expectations for future volatility. While from an academic standpoint there is some logic to inferring future volatility from option prices, from a practical standpoint the VIX is not an investable index. Unlike a standard stock index where one can simply purchase and hold the stocks in the proper weights, no one has yet devised a way to directly buy the VIX.
Instead, most products that try to capture the VIX movements do so via the use of short-term futures. Futures are of course another type of derivative, so a future on the VIX is really a derivative of a derivative. Futures have their own unique pricing complexities. In the case of VIX futures, the futures almost always trade at a premium to the VIX, a situation known in the futures market as “contango”.
Because these are short-term contracts, a VIX futures strategy must constantly be buying futures that are almost always more expensive today than they will be in the future. In practical terms, this means consistently maintaining a position in VIX futures will almost always lose money.
In addition, most volatility ETPs are passively managed. This is tricky when volatility conditions change extremely fast. Anyone who has kept an eye on daily movements in the VIX or related ETPs knows that double-digit daily moves are not uncommon. Yet many volatility ETPs are methodically managed in a passive fashion and are not designed to react to changing market conditions.
Finally, the very fact that the prices of volatility ETPs are so volatile themselves make them inappropriate as a long-term investment vehicle and impractical as a hedging vehicle. As discussed in a previous Swan article for ETF Trends (link), variance drain deteriorates the long-term value of any investment. Generally speaking, the more volatile an asset and the longer the holding period, the more variance drain will diminish its value. Since volatility ETPs are so volatile, the impact of variance drain is especially pronounced.
If one intends to use volatility ETPs to profit from volatility, the time horizon must be very short – not much longer than a few days or weeks, in most cases. The factors discussed – contango, passive management, and variance drain – make volatility ETPs a poor choice for hedging or long-term investing.
However, if one wishes to harvest the so-called volatility premium over longer time horizons, it is the opinion of Swan Global Investments that you need to do so directly. If you want to profit from the fear and volatility that is priced into current options, you must trade the options themselves. Also, given how quickly things change in the options market, it is essential to have active management and strict risk controls in place to mitigate and manage the risk of a volatility capture strategy. This approach to premium harvesting is one of the components of Swan’s Defined Risk Strategy (DRS). For 19 years the DRS has systematically attempted to collect the volatility premium by selling out of the money calls and puts on the S&P 500. The DRS combines volatility capture, long exposure to the market via ETFs, and effective hedging techniques in a single strategy designed to provide consistent returns throughout rising, declining, or flat markets.