Daily resetting products exhibit positive convexity (the returns of the instrument increase more rapidly and decrease less rapidly than an equivalent linear exposure); however, the trade-off is that they also exhibit return decay in many return environments. Therefore, a stand-alone position in a daily resetting product should only be initiated in place of a nonresetting position if the trader expects the positive effects of the convexity to outweigh the negative effects of the return decay for the period.
Non-Normal Returns In VIX Futures
As mentioned earlier, the expected return analysis assumes a normal distribution of returns. This assumption clearly does not hold for VIX futures. The VIX-related ETPs are linked to the VIX futures indexes (not the VIX), and the returns on the indexes exhibit a number of non-normal characteristics: They have a negative mean, exhibit high positive skew and tend to trend. The trending behavior should theoretically improve the performance of the daily resetting products relative to nondaily resetting products. The non-normal distribution of the returns of the S&P 500 VIX Short-Term Futures Index is evident when compared with the returns of the VIX and SPX (see Figures 11 and 12).
Developing A Volatility Strategy
The dismal performance of the S&P 500 VIX Short-Term Futures Index since its inception relative to the VIX and the usual shape of the VIX futures curve (contango) make it look attractive to be “short” the short-term index. That said, and as Figure 13 shows, there is a significant risk to being short volatility. While a daily resetting position in the inverse of the short-term index has produced a total return of 249 percent from January 2009 through August 2011, there have been periods when the inverse of the index sustained large losses, i.e., October 2008 and August 2011, when the inverse position would have suffered significant losses. There are a number of strategies a manager can employ to mitigate the exposure to a spike in volatility, such as buying out-of-the-money calls or taking a long exposure to VIX-related instruments.