August 30th, 2012
by Ari Charney, Featured Expert, Investing Daily
With the VIX still trading near the 52-week low of 13.30 it hit last Friday, it may be tempting to go long on volatility via one of the VIX-linked exchange-traded products (ETPs). After all, the extreme complacency suggested by the VIX as of late rarely persists for long. And with the market trading near five-year highs, it’s only a matter of time before downward volatility reasserts itself, perhaps sometime after Labor Day, when Wall Street’s trading desks are fully manned again after the lull of the summer vacation season.
VIX-linked ETPs may offer retail investors the allure of playing volatility with ease, but most don’t actually mirror the performance of the widely cited VIX. In fact, the manner in which their portfolios are constructed means that ETPs that should perform well when the VIX rises can actually lose money.
What Is This VIX of Which You Speak?
But before we delve into such esoterica as portfolio construction, let’s review what the VIX is and what precipitated its ascendance in the mind of the average investor.
Until several years ago, the retail investor regarded the VIX as an obscure market indicator that only professional traders monitored. The VIX, which is formally known as the Chicago Board Options Exchange Market Volatility Index, is also known colloquially as the “fear index.”
By tracking a basket of options based on the S&P 500, the VIX is an attempt to gauge the implied volatility of the S&P 500 over the subsequent 30-day period. In other words, VIX readings are suggestive of the percentage range of returns the S&P is likely to experience over the short term. Similar to market sentiment, traders watch the VIX for signs of complacency during the market’s bullish periods and signs of extreme anxiety during bearish periods.
For the investing public, the VIX finally came to fore during the dark days of late 2008 when the VIX, which had been trading in the low 20s for most of the year, suddenly rocketed past 80 in October and November. Those readings reflected the wild volatility and extreme pessimism that characterized the market during a period when the entire financial system appeared to be on the verge of collapse. At the time, the VIX was still relatively new, so investors could only trade the VIX via futures and options.
Wall Street Attempts to Capitalize on the VIX
But ETP sponsors were quick to capitalize on the sudden emergence of the VIX in the mainstream financial media, and the first VIX-linked exchange-traded notes (ETN) were launched by Barclays just a few months later in January 2009. Among this pair, the iPath S&P 500 VIX Short-term Futures ETN (NYSE: VXX) is still the best known VIX-linked ETP, dwarfing the size of its peers with its ample trading volume and total assets of almost $1.7 billion. As such, we’ll focus our analysis on this ETN.
But first, it should be noted there are now almost 30 other investment products that are based on the VIX, including leveraged and inverse ETNs. These latter products are especially dangerous for retail investors because their portfolios reset on a daily basis, and their use of leverage magnifies losses in such a way that these securities would eventually hit zero, if not for their sponsors’ interventions via reverse splits.
So while the standard VIX products are a poor proxy for the VIX, these inverse and leveraged products could be disastrous for the average investor’s portfolio. In fact, I’ve often wondered if even professional traders are able to successfully exploit these products on a consistent basis.
The ETP industry has attempted to mitigate the problem posed by daily portfolio resets by offering leveraged products with monthly resets and even “extended” resets. But that still doesn’t overcome the risk that’s always inherent in leverage, or the relatively high management and financing fees associated with such products.
The Pitfalls of ETNs
Nearly all of the VIX-linked ETPs are structured in the form of ETNs. Investing Daily editors Benjamin Shepherd and Jim Fink have written extensively about some of the pitfalls associated with investing in ETNs. ETNs are actually senior unsecured debt instruments backed by the creditworthiness of the entity that issues them. Given the existential questions that arose during the downturn about the resilience of the financial sector, the failure of a financial institution is no longer an academic consideration.
In addition to the possibility that the value of an ETN could get wiped out if its issuer goes bankrupt, ETNs also face the possibility that the institution that created them could halt issuance of new shares. This problem beset VIX investors earlier this year when Credit Suisse temporarily suspended the creation of new shares in VelocityShares Daily 2x VIX Short-term ETN (NYSE: TVIX). The ETN had been colorfully dubbed “General TVIX” by traders who attempted to ride it higher when volatility peaked as Europe’s debt crisis roiled global markets last fall.
But General TVIX was ultimately a victim of its own success. Investors poured so many assets into it that its sheer size apparently ran afoul of Barclays’ internal controls. The halt in issuance created a scarcity of shares, which caused share prices to deviate significantly from their benchmark–at one point, the ETN was trading at a premium of nearly 90 percent to its net asset value–and then crashed roughly 50 percent in the two days following the limited resumption of issuance. As a result, a lot of investors got burned by the quirk of a security that had nothing to do with its actual benchmark.
But even the relatively staid VXX is problematic. Because investors can’t trade directly in the VIX itself, VIX-linked ETN portfolios are typically comprised of futures. In the case of VXX, the ETN invests in “a daily rolling long position in the first- and second-month VIX futures contracts.” That means these investment vehicles will never mirror the VIX itself, but the prices of the futures derived from it.
It Takes Two Futures to Contango
More important, however, is the fact that ETNs that use futures face the problems of both contango and backwardation. Contango occurs when forward-month futures are trading at a higher price than the futures in the spot market, while backwardation is the opposite scenario.
Unfortunately for would-be VIX investors, analysts at JPMorgan determined that volatility futures have been in contango about 71 percent of the time since they began trading in 2004. Contango has eroded the value of numerous ETPs whose portfolios invest in futures. When the futures market is in contango, that means the ETN is essentially forced to sell low and buy high when it rolls contracts each month. In fact, shares of VXX have dropped 97.1 percent from the price at which they originally started trading back in 2009.
The bottom line is that VIX-linked ETPs should solely be the province of those professional traders who know how to profit from their peculiar features. Retail investors should content themselves with employing the VIX as a market indicator, not a new asset class.
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