VIX Instruments: Why Investing in Volatility is Volatile
by Justin Dove, Investment U Research
Wednesday, September 7, 2011
The VIX Index is all over the place in financial media these days. As most investors gather, the VIX is a volatility measure that looks to quantify fear in the markets.
Many media outlets report from time to time that the VIX, or the Chicago Board of Options Exchange (CBOE) Volatility Index, is heading towards record levels. Surely there are plenty of investors wondering how they can get a piece of the action.
When most stocks are falling, who wouldn’t want to capitalize on an index that seems to keep rising? After all, fear in the markets is one of the few things that’s becoming predictable.
The VIX is a statistic that can’t be traded. It’s a mathematical computation derived from S&P 500 options trades. The VIX looks to gauge how bullish investors are on the future by analyzing options activity.
In 2004, the CBOE allowed VIX futures contracts to be traded. Then, in 2006, the CBOE began trading options on the VIX. More recently, investment banks such as UBS (NYSE: UBS), Citigroup (NYSE: C) and Barclays PLC (NYSE: BCS) have created exchange-traded funds (ETFs) and exchange-traded notes (ETNs) that claim to track the VIX.
Understanding These VIX-Based Instruments
The first equity-traded instrument created to track the VIX Index was Barclays’ iPath S&P 500 VIX Short-Term Futures ETN (NYSE: VXX). An ETN is different from an ETF because it’s a debt instrument. There’s credit risk involved. Although it’s unlikely Barclays would default, it did happen to Lehman Brothers in 2008.
As implied by its name, the VXX tracks short-term futures, while the iPath S&P 500 VIX Mid-Term Futures ETN (NYSE: VXZ) tracks longer-termed VIX futures.
The chart above shows that the VXZ is a bit less volatile than the VXX. They show correlation, but both have incurred major losses in the past year.
When the VXX is compared to the VIX itself, things become more alarming.
While the correlation is apparent, it’s obvious that the VXX continues to diverge from the index it’s supposed to track. Surprisingly, this is how it’s designed. The VXX and VXZ are using the purchase of futures contracts. The time-value of money makes the futures contract more expensive when it’s purchased and less expensive when it’s redeemed. This phenomenon is called “contango.” Contango gives VIX futures a negative roll yield.
Why VIX Instruments Are Not a Good Hedge
The point of diversification and asset allocation is to hedge investments so that large dips in some investments are eased by the performance of other investments. Precious metals and treasuries are examples of good hedges for stock investments. VIX instruments are not.
A study by the University of Reading’s ICMA Centre found that diversifying using volatility instruments could be hazardous. They stated that:
“Perfect foresight would seldom justify the purchase of VIX futures as a long equity diversification tool. Most of the time volatility’s negative carry and roll yield heavily erodes equity performance, and the only time volatility diversification is optimal is at the onset of a stock market crisis.”
The conclusion goes on to state that such stock market crises are hard to predict and relatively short in nature. Therefore, “by the time we are aware of a crisis it is usually too late to diversify into volatility.”
VIX Instruments Uses
While these instruments are just two examples of a slew of VIX-based equity instruments, similar problems exist across the board. It’s nearly impossible to track a statistic with an investment product. So if they aren’t useful for investors, what are these VIX instruments good for?
They’re useful for speculators and traders. Traders are more like gamblers than investors. Suppose a trader speculated that a piece of news would strike fear in the hearts of investors. He may enter a position in VelocityShares Daily 2x VIX ST ETN (NYSE: TVIX), which doubles the weight of movements in VIX futures.
There’s still an ultimate downward slope over the long term and large dips. But in volatile markets such as these, this type of instruments can go up in a hurry. People who time it right can make a pretty penny. However, many amateurs don’t have the time, knowledge, or resources to accurately time markets like this.
Safer Portfolio Hedges Than VIX Instruments
These volatility instruments are mainly for gamblers, not investors. Many people have played the market-timing game, and most fail. Instead of trying to play volatility, consider these safer portfolio hedges to uncertainty in the market.
- Precious metals – Gold gets most of the news, but silver, platinum and palladium are all bound to appreciate as people look for safer investments. Precious metals mining equities and ETFs are also cheaper, viable alternatives. Because precious metals ETFs, such as SPDR Gold Trust (NYSE: GLD) or iShares Silver Trust (NYSE: SLV), actually hold physical commodities, there’s no contango effect as in VIX futures instruments.
- Municipal Bonds – All interest rates are slumping for the foreseeable future, but the current yield on a 10-year municipal bond is about 2.3 percent. Add in the tax-free aspect and it’s closer to 3.2 percent. That’s much better than a CD or U.S. Treasury right now.
- Inverse S&P 500 ETFs – If you really want something in the portfolio that’ll counter the dips in the market, consider an inverse S&P 500 instrument. ProShares Short S&P 500 (NYSE: SH) moves exactly opposite to the S&P 500 Index. So when stocks are falling, a rise in this will help offset any losses.
These volatile times in the market are very trying for all investors. It’s natural to want to capitalize off of the volatility that we have all come to expect from the markets. But asset allocation and diversification are still the lowest maintenance and safest ways to get through these times.