Sometimes how we feel about the market bears absolutely no resemblance to reality. When I look back at 2016, I’m exhausted. And when I talk to many advisors, I hear similar comments: “What a year!” they say. “We had such an awful winter, and then all the craziness around the election!”
But the reality is that this was actually one of the most placid years in recent history. Here’s the actual, 30-day realized volatility of the S&P 500 for the last 10 years:
What this excellent chart from Bloomberg suggests is that our current market is in one of the lowest volatility periods we’ve seen in ages, and while we’ve had some spikes, particularly in the spring, it’s just about as boring a market as you can get.
Of course, you can’t actually trade this chart; instead, what you can trade, sort of, is the CBOE Volatility Index, or VIX—a derivative calculation based on the implied volatility of strips of S&P 500 options. Here’s what the VIX chart looks like over the past 10 years:
Even the quickest glance suggests these are pretty good proxies for each other, and while they’re not identical, they even “base” around the same number: 10 for low-vol periods, 80 for crazy spikes.
And using options is actually sensible, because for a sophisticated investor, making a specific bet on volatility would most easily be done with options. You want to bet the S&P 500 is going to spike in either direction? Options players have a plan for you—a straddle. Think we’re range-bound and want to bet on it? The wonderfully named Iron Condor is for you.
Managing volatility is in fact what options are designed to do, so that’s why the CBOE uses the real-world expressions of sentiment from options traders to compute the VIX.
The Contango Conundrum
Like options themselves, there’s nothing inherently bullish or bearish about the VIX itself. Using either options or futures contracts on the VIX index, investors can bet on either increasing or decreasing volatility.
The problem is that in a low-volatility environment like we’ve been in, most investors are going to guess that future volatility will be higher than today’s volatility, and thus they will bid up the price of the futures contracts themselves. A lot. Here’s what the futures curve looks like right now for the VIX:
With VIX at 12, buying the front-month futures contract will cost you 14. To put that in perspective, that means that, if VIX remains at 12, you can expect to lose $2 for every $14 invested in a single month. That $2-a-month decay continues from the first to the second month as well.
That means even if you’re right, and VIX is going to rise, you’re facing a 14.2% head wind every month. That’s a 396% head wind every year. Of course, the contango isn’t always this bad, but it’s generally been sharply upward-sloping all year long.
If you think that means investing in a long VIX-futures-based ETF for the last year has been tough, you’re right. The top three worst-performing ETFs over the last year all track near-month VIX futures contracts: the iPath S&P 500 VIX Short-Term Futures ETN (VXX), the VelocityShares Daily Long VIX Short-Term ETN (VIIX) and the ProShares VIX Short-Term Futures ETF (VIXY).
‘Force Of Nature’ For Investors
The reason you can’t see three ETF lines on the chart is because these funds are, for all intents and purposes, identical in their returns. The problem is contango: It’s a force of nature, and there’s no getting around it as a futures investor.
While this isn’t a pretty chart, it’s worth noting that these funds have done exactly what they said they were going to do day after day. If you went into the month of June with a position in one of these funds, you were up over 25% in a matter of days as you caught the pre-Brexit spike in volatility.
But remember, the VIX was never intended as some sort of “long only” asset to invest in—it’s a measurement of the state of the market, just like humidity is a measurement of the state of the atmosphere.
Investors can, and do, capitalize on it in other ways, either by shorting funds like this to capture contango, or investing in the suite of inverse products, such as the VelocityShares Daily Inverse VIX Short-Term ETN (XIV) or the ProShares Short VIX Short-Term Futures ETF (SVXY), that take the opposite bets:
Again, two strategies following the same basic strategy—taking the “sell” side of the VIX futures trade. These funds not only profit from contango, they’ve also benefited from relatively calm fluctuations in the VIX itself, which means the daily-rebalance effect common to most leveraged and inverse funds hasn’t cut into returns.
Of course, just like June was a great time to be in the long ETFs, it was murderous for these funds: If you got the timing wrong, you could have been down more than 35% in a matter of days when volatility spiked.
What’s In An (Inverse) Name?
Honestly, at ETF.com, we can end up trapped a bit by our own analytical framework. As a matter of course, we exclude leveraged and inverse funds from things like performance charts, because otherwise, every list would be nothing but the most levered version of whatever theme was hot (or awful) at the time. But in the case of VIX, that leads to some missed opportunities for analysis.
A long bet on the VIX is no different than a short bet on the VIX in theoretical terms. VIX is mean-reverting by definition, unlike any other investment I can think of in finance. So to my mind, this bizarre year, or relatively calm markets but high anxiety, has made VIX ETFs both the worst and nearly the-best-performing products in the market.
At the time of writing, the author held no positions in the securities mentioned. Contact Dave Nadig at [email protected].