Political risk and uncertainty surrounding presidential election have dragged on the equities market.
Investors, though, have hedged the risk through CBOE Volatility Index, or VIX, related exchange traded funds.
On the recent webcast, Trading VIX to Hedge Market Risks: What You Need to Know, Vinit Srivastava, Managing Director of Strategy and Volatility Indices at S&P Dow Jones Indices, pointed out that the VIX, or so-called investor fear gauge, typically touches its highest level during periods of market turbulence.
The VIX has historically shown a negative correlation to the S&P 500, which provides a suitable diversify during broad market selling. From January 1990 through August 2016, the VIX has exhibited a -0.71 correlation to the S&P 500 – a negative 1 reading implies perfectly noncorrelated assets whereas a positive 1 reading reflects perfect correlation.
“Implied equity volatility has historically had a strongly negative correlation to equity market returns and is considered a useful tool to hedge against the potential downside of the broad equity market,” Srivastava said.
Investors can gain exposure to VIX movements through the futures market and index-backed strategies that track VIX futures. However, the S&P 500 VIX Futures Index Series does not perfectly track the VIX spot price. Futures are less sensitive than the VIX spot to market movements, and the sensitivity declines with longer-dated VIX contracts.
“The implied forward volatility that these prices represent may not always track the VIX,” Greg King, Founder and CEO of REX Shares, said.
Moreover, since investors will be dabbling in the options market, futures traders will be exposed to the VIX term structure, or roll yield as determined by their term structure, which may result in contango or backwardation. Specifically, the VIX indices, along with related futures-backed VIX exchange traded products, are negatively affected by contango when rolling futures contracts.
[related_stories]Before the VIX contracts mature, the VIX indices and VIX ETPs will execute a forward roll or sell expiring contracts and buy a later-dated contract. However, when the futures market is in a state of contango, later-dated contracts cost more than near-term contracts, so the indices and ETPs essentially sell low and buy high on each roll.
Bill Luby, Chief Investment Officer of Luby Asset Management, explained that over the short-term, VIX ETP prices are determined by volatility, but over the long-run, term structure or the negative effects of contango will determine VIX ETP prices.
“In the S&P 500 VIX Short-Term Futures Index, a positive roll cost occurs on 76% of days, with an average daily loss of 0.18%,” Srivastava said. “In the S&P 500 VIX Mid-Term Futures Index, a positive roll cost occurs on 64% of days, with a lower average daily loss of 0.07%.”
Volatility traders who are interested in short-term moves may be focused on more near-term VIX futures, which have shown a greater sensitivity to short-term VIX spot moves.
“High beta makes VIX ETPs darlings of day traders focusing on directional changes,” Luby said.
Consequently, King argued that traders may be more interested in short-dated VIX ETP exposure, such as the REX VolMAXX Long VIX Weekly Futures Strategy ETF (BATS: VMAX) and the REX VolMAXX Inverse VIX Weekly Futures Strategy ETF (BATS: VMIN) to gain exposure to VIX up and down movements, respectively. The VolMAXX funds have a target weighted average time to expiration of less than 30 days by accessing VIX weekly futures, unlike other ETP options that utilize monthly contracts.
“More frequent expirations allow for consistent short dated exposure,” King said.
Financial advisors are seeking VIX ETPs that more closely track the VIX Index. In a survey of advisors on the webcast, 84.0% of respondents said they are more likely to trade a volatility ETF that was more highly correlated with the VIX.
Financial advisors who are interested in learning more about the CBOE Volatility index can watch the webcast here on demand.