Volatility ETFs Require Perfect Timing To Work

July 11, 2014

For VIX-related ETFs to work as that ‘magical’ hedge, you have to time the market. Good luck with that.

I’ve never been a fan of VIX-based ETFs as “hedges.” The last 12 months haven’t changed my mind.

It’s natural to be nervous about the market. I literally cannot remember a year in my life where, at some point, I wasn’t really nervous about the market. When we’re in the middle of a rally, we’re waiting for the other shoe to drop. When we’re in the middle of downdraft, it seems like the world is on fire and everything’s a disaster.

So everyone wants a hedge. But they don’t want a logical hedge, they want a magical hedge. They want an inexpensive, easy-to-implement investment that will protect them from downsides while giving them all of the upsides. Such a beast has never really existed, no matter how many Ph.D.’s in finance have tried to create them. There’s always a cost, and there’s always a balance of risk-takers and risk-avoiders.

The most recent and alluring magical hedge has been ETFs based on volatility indexes. Now I’ve written a ton about this in the past. I’ve written about how volatility ETFs can often own all of the VIX futures that exist. I wrote a year ago about how I thought that, in general, the largest ETF in the space—the iPath S&P 500 VIX Short-Term Futures ETN (VXX | A-47)—was fundamentally a pretty bad way to “insure” a portfolio.

Given the relatively sanguine markets of the last year, I thought I’d check in and see how VXX investors have done. First, here’s the chart:

Hedge

Source: Bloomberg

In the past year, the S&P 500 is up more than 21 percent. VXX, unsurprisingly, is down almost 60 percent. The reasons for this are fairly simple—it’s enormously expensive to maintain a VIX futures position, because next month’s VIX future is almost always more expensive than the one that’s expiring. That contango is the killer.

But how has VXX done when the markets had pullbacks? To answer that, I divvied up the last year into periods where the market experienced drawdowns of more than 3 percent, and the periods in between. It’s a somewhat arbitrary process, but I think similar to how most people would draw lines on the chart. Here are the results:

 

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