Volatility ETFs: Both Lousy Hedge & No-Win Bet

September 10, 2015

The VIX is back on the downswing. After peaking for a brief moment above 53 on Aug. 24, the CBOE Volatility Index has halved to about 25, as of this writing.

That's not unusual. The VIX, which measures the implied volatility of near-month S&P 500 options, tends to spike most dramatically when market fears are the highest.

Spot VIX & Front-Month VIX Futures

On Aug. 24, when the S&P 500 plunged as much as 5.3 percent (and the SPDR S&P 500 ETF (SPY | A-99) fell as much as 7.8 percent), that fear reached its maximum point.

Since then, concerns have abated, though they still remain somewhat elevated. Any VIX reading above 20 is seen by many investors as a sign of trepidation.

But if stocks stabilize and ultimately resume their climb, the path of least resistance is down for the VIX. That bodes ill for ETFs like the iPath S&P 500 VIX Short-Term Futures ETN (VXX | B-62), which tracks near-month VIX futures contracts.

Bad Hedge

A perennially poor performer, VXX and similar products such as the ProShares VIX Short-Term ETF (VIXY | B-61) and the VelocityShares VIX Short-Term ETN (VIIX | B-62) have lost tremendous value over virtually every time period.

Since its inception in January 2009, VXX is down 99.6 percent; from a year ago, it’s down 2.8 percent; and year-to-date it's down 15.1 percent.

For a product regarded as a hedge by many, the ETN isn't doing its job very well. In fact, all throughout this correction in the stock market, VXX has remained in the red for the year.

At its best point on Sept. 1, VXX nearly broke even for 2015, but quickly fell deep into the red again.

YTD Returns For VXX, SPY

An investor who bought the ETN as a hedge against a market correction at the beginning of the year never benefited from the spike in the VIX.

Contango Cost

The biggest problem for VXX is contango. By tracking VIX futures, the ETN is heavily impacted by the shape of the VIX futures curve. Here's that curve at the start of the year:

When the VIX futures curve is upward sloping, as it is most of the time, it's in a condition called contango.

VXX, which tracks the first- and second-month VIX futures, must constantly roll its exposure forward as those contracts expire. For example, at the start of the year, it was tracking January and February contracts, but once the January contract neared expiration, it rolled over its exposure and began tracking the March contract.

Because March contracts were more expensive than January contracts, the ETN couldn't afford as many, resulting in a "roll cost" for VXX holders.

Over time, this cost adds up, and is the primary reason VXX is down an eye-popping 99.6 percent since its launch, and down significantly in every year since inception. Fluctuations in the underlying VIX Index matter, too, but over longer-term horizons, contango are what's been killing returns for the ETN.

Year VXX Return (%)
2009 -65.9
2010 -72.4
2011 -5.6
2012 -76.4
2013 -66.6
2014 -25.9
2015 -15.1

Trading Tool

This is not to say that no one's made money. Buyers of VXX in mid-August, right before the market plunge, nearly doubled their money at one point. But to experience those gains, one would have had to have had impeccable timing.

That makes VXX more of a speculative trading tool than a hedge.

The Bottom Line

If the stock market falls low enough and the VIX spikes high enough, VXX may move into the green for the year. But that still wouldn't make the ETN a good hedge.

For insurance and diversification, an investor is better off buying safe-haven bonds or other assets that are negatively correlated with equity returns, but that don't destroy enormous amounts of value over time.

At the tiem of writing, the author held no positions in the securities mentioned. Contact Sumit Roy [email protected].

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