Consequences Of Contango In The VIX Futures Market
Since the launch of the first VIX-related ETPs in January 2009, the futures contracts underlying the VIX futures indexes generally have been in contango. The contango in the futures market results in the index losing value every trading day if future prices do not move higher than discounted in the market—the value of the contracts is falling as they roll down the futures price curve. The 20-day rolling average spread between the first- and second-month futures contracts has averaged 3.8 percent per month since the inception date of the index in 2005, but has averaged a much steeper 6.2 percent per month since the introduction of the VIX ETPs in January 2009. At the same time, the supply/demand dynamic for VIX futures changed dramatically.
Many futures markets are in contango from time to time, but the VIX futures market, with the exception of a handful of days, was in contango from mid-2009 through July 2011. A number of theories was put forth as to why: One theory is that the introduction of VIX-related products created continued demand to buy the second month and sell the first month in line with the index. Another posits that after the 2008 stock market crash, investors were willing to pay a higher premium for longer-dated volatility exposure that would provide them “protection” from a sell-off in the equity market. In the fourth quarter of 2008 and again in August 2011, the VIX futures curves tend to go into backwardation when the market undergoes significant spikes in volatility.
The contango in the VIX futures market has had a significant impact on the performance of the S&P VIX Futures indexes. The degree of this impact is most evident when looking at the relative performance of the short- and mid-term indexes. Figure 6 depicts the level of the short-term and midterm indexes since inception against the level of VIX. The short-term index has lost 85 percent since inception, and fell 44 percent in the first half of 2011. During those same periods, the midterm index posted returns of 29 percent and -23 percent, respectively. While the two indexes suffered double-digit negative returns during the first half of this year, the VIX was down only 7 percent. This relative performance clearly highlights the cost of a buy-and-hold position in the S&P 500 VIX Futures Index due to the contango in the futures market.
Clearly, the S&P 500 VIX Short-Term Futures Index is not the same as the VIX. Since the index’s inception through August 2011, the daily return of the short-term VIX futures index has a beta of almost 0.5 with spot VIX, and the beta on the midterm futures index is approximately 0.2.