Using ETFs for crash protection: a look at the VIX ‘fear index’
The VIX, or volatility index, gets a lot of media coverage as a barometer for investor sentiment. But what is the VIX, and can you actually trade it? Here we explain how it works and why investors wanting to protect their portfolios against falling markets should tread carefully.
If you feel that equity markets are due a correction, you may have considered buying a volatility exchange traded note (ETN). Many investors are interested in these products as ‘realised’ equity volatility (a measure of how much prices deviate from their historic average) is very low at present, due to the market forecasting stable economic growth and a steady increase in company earnings.
The media and investors like to look to the future to try and understand how investors are positioned for upcoming events. The most widely talked about measure is the VIX index which measures ‘implied,’ or expected volatility, through observing the price changes in near-term S&P 500 options prices. In Europe we have a similar measure, which gets less coverage, the VSTOXX index that measures volatility on Eurozone (Euro Stoxx 50) options.
These rather obscure indices get a lot of headlines as investors that want to profit from market volatility, or, as increased volatility is usually synonymous with market sell-offs, to hedge their portfolios against market declines, are naturally attracted to products which price off volatility measures.
In the graph below we can see that the VIX can be subject to extreme variations in value when market volatility picks up. The VIX is currently at a record low of below ten, but in the crash of 2008 it reached a peak closing price of 80 (the intraday price was higher). This makes it very attractive to investors that hope they can buy the index when it is low and then sell when it is high, potentially making a multiple of their investment.
Chart 1: VIX Index (monthly closing prices)
Unfortunately it is not as easy as that, as the VIX is a mathematical calculation rather than an index of stocks or bonds, and the only way to trade it is by buying a derivative contract (a future) based on its value.
At present traders believe that volatility is going to pick up, and this means that volatility futures are priced accordingly - greatly in excess of the VIX spot price, which we will see later on.
How to trade the VIX: Volatility ETNs
There are a number of ETNs listed in London which investors can buy. ETNs are like exchange traded funds (ETFs), except that rather than holding stocks and bonds they own derivative contracts. In London there are listed volatility ETNs based on either the VIX or the VSTOXX index.
For ease of comprehension, we have analysed two VIX ETNs issued by iPath in the following paragraphs.
In chart 2 we can see the performance year to 17 July of both the iPath S&P 500 VIX Short-Term Futures ETN (VXIS) and the Mid-Term Futures equivalent (VXIM) compared to the VIX. Both have underperformed to varying degrees, with the VXIS having a worse total return (but with more volatility) than VXIM.
Chart 2: Performance year to date of VIX ETNs vs. the VIX Index
Charts 3 and 4 taken from the iPath website illustrate which VIX futures the ETNs are invested in. VXIM has four futures positions, while VXIS has just two in the July and August contracts.
Chart 3: iPath VIX Short-Term Futures Index ETN (VXIS)
Chart 4: iPath VIX Mid-Term Futures Index ETN (VXIM)
In chart 4 we show the current shape of the VIX futures curve, highlighting which contracts the ETNs own. The short-dated ETN has allocations to the July and August futures, which have to be regularly rolled as they get closer to the delivery date. The futures curve is upward sloping, which in the industry is known as ‘contango,’ or a ‘negative roll yield.’ Therefore, each time a roll occurs, there is a cost to the portfolio. Rolling from the July future (price at 10.3) to the August future (priced at 11.96) has a cost of 13.8%. This is the reason that the short-dated ETN has underperformed the VIX spot price by so much year to date.
Chart 5: VIX Futures Curve as of 18 July 2017
Were you to own the medium-term futures ETN, we can see immediately that the structure of the futures curve is not as steep, meaning that the roll cost is less. And because the ETN holds the futures for longer, this also has less of a negative impact on returns.
As with most things in finance there is no ‘free lunch.’ What you gain in terms of lower roll costs, you lose in terms of sensitivity to the VIX spot price.
Longer-dated futures will always be less sensitive to the spot price due to the time value embedded in the option. This is polar opposite to holding long-dated bonds which are much more sensitive to changes in yield, the longer the maturity of the bond.
For medium-term VIX futures to substantially profit from a change in volatility you would need a structural shift in the VIX value from the lows we are at now more towards the mid teens Longer-dated futures are simply not as responsive to short-term volatility as the short-term (but more costly) futures ETN.
How should I trade these volatility ETNs?
As with most financial instruments, volatility ETNs can have a place in your portfolio but they just mustn’t be held for more than a very short period of time when the futures curve is significantly upwards sloping as it is now. A better way to hedge your portfolio risk may be to hold cash reserves, or to use unleveraged products that short an index. You might also want to consider long-dated government bonds, but there is no guarantee that they will have a negative correlation to equities in a risk off scenario.
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