VXX May Be Losing Its Hedging Mojo

May 08, 2013

Using VIX-based ETPs to hedge equity positions has never been easy or cheap. Is it now less effective too?

 

With major U.S. equity indexes setting new highs, some investors may be bracing for a major correction downward.

To hedge their equity positions, these investors may be tempted to reach for a VIX-based product. Products based on the CBOE Volatility Index, or VIX, are often used as equity hedges because the VIX and the S&P 500 Index tend to move in opposite directions.

However, a recent Bloomberg piece noted that this relationship—the strongly negative correlation between the VIX and the S&P 500—may be weakening.

The VIX may be the market’s leading measure of volatility and its mechanics are interesting, but they’re not actionable. Investors can’t access the VIX index—it’s uninvestable. Instead they gain exposure to it using VIX futures.

But VIX futures offer an imperfect vehicle for VIX index exposure due to the shape of the futures curve— as has been noted ad nauseum by analysts and bloggers, including me.

All this is preamble. When I saw the Bloomberg article, I immediately wanted to know whether correlations between VIX futures products and the S&P 500 had changed.

Cut To The Chase

Correlations change all the time. Here’s a graph of rolling correlations between the iPath S&P 500 VIX Short-Term Futures ETN (NYSEArca: VXX) and the SPDR S&P 500 ETF (NYSEArca: SPY). I used a 22-trading-day rolling period, equal to a calendar month. That’s a short window, but one that’s realistic for a tactical hedge using VIX futures products. On the chart, values approaching -1 (at the bottom) are ideal for hedging purposes.

 

Rolling Correlations VXX vs SPY: 22 days

 

While the chart doesn’t show a clear trend that negative correlation has decreased recently, it does show that correlations are increasingly unstable in 2013. The hedging power of VXX lies in strong negative correlation, and when this aspect of performance is less reliable, the hedge is less reliable as well.

 

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