Volatility ETFs Require Perfect Timing To Work

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

Reviewed by: Dave Nadig
Edited by: Dave Nadig

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:


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:



7/10/13 - 8/2/133.49%-19.31%23
8/2/13 - 8/27/13-4.46%16.00%25
8/27/13 - 9/18/135.95%-17.42%22
9/18/13 - 10/8/13-3.91%24.25%20
10/8/13 - 1/22/1411.97%-41.08%106
1/22/14 - 2/3/14-5.50%32.65%12
2/3/14 - 4/2/148.93%-22.60%58
4/2/11 - 4/11/14-3.90%9.04%9
4/11/14 - 7/10/148.59%-36.54%90

So what does this tell us? First of all, it should tell you that the returns of VXX are vastly more volatile than those of the SPDR S&P 500 ETF (SPY | A-98). VXX, at least over these periods, responds to movements in the S&P 500 anywhere from three to 10 times as violently as the move in the index itself. But it’s also worth throwing a bone here to VIX lovers, as, indeed, in every period the S&P was down, VXX was up, and vice versa. That is, at least on the surface, what folks say they want out of VIX.

Here’s another way to look at the data:

  Total ReturnAverage Day
Rally Periods29938.92%-136.95%0.13%-0.46%
Down Periods66-17.76%81.94%-0.27%1.24%

During the calendar windows of “upmarkets,” the S&P racked up almost 40 percent positive returns, offset by nearly 18 percent drawdowns during those gut-check periods. VXX did essentially the opposite—with authority—gaining more than 81 percent during those drawdown windows, offset by 136 percent losses during the S&P’s good times.




Put another way, an average up period for the S&P consists of 0.13 percent up days, during which VXX will lose almost 0.5 percent a day. On the flip side, when the S&P is on a losing streak, it loses about 0.25 percent a day, while VXX rockets up 1.25 percent.

That’s the back-of-the-envelope math, but what about the really nerdy way of looking at it? What if we’re not looking at these longer periods, but just at individual trading days?

 # of DaysCorrelationR2Beta
Up Days148-0.700.49-3.94
Down Days104-0.720.51-3.78

This above table splits all of the individual trading days of the last year into the up days in the S&P, and the down days. In case you’ve forgotten your stats classes, there’s mostly bad news in here.

The worst news for VIX fans is that you have a higher negative beta on the days when the market is up than you do on the days when the market is down. That is, in a sense, your “leverage” to the S&P 500. On a day it’s up 1 percent, the beta would suggest VXX is down 3.94 percent. More bad news is that the negative correlation between VXX and the S&P 500 we’re praying for is not only weak (at about -.70) but incredibly unreliable (R-squareds of 0.5 imply essentially a coin flip over whether you should believe the data).

In fact, of the 252 trading days in the sample, there were 25 days when both VXX and SPY were down, and another 25 when both VXX and SPY were up at the same time.

So what to make of all this admittedly complex analysis of a short time period? I come right back to where I’ve always been. VXX works great, but only if you know exactly when to hold it. If you’re enough of a genius to know with certainty when the market is going to be down for multiple days in a row, then VXX is a great leveraged way to capitalize on your superhuman powers of precognition.

If, however, you’re simply nervous and plan on holding it “just in case?” Well, VXX continues to be a terrible way to approach the problem.

(Note: For a deeper dive on when you might be able to eke out some benefit from VIX products, subscribers should check out this month’s issue of the ETF Report.)

At the time this article was written, the author held no positions in the securities mentioned. Contact Dave Nadig at [email protected].


Prior to becoming chief investment officer and director of research at ETF Trends, Dave Nadig was managing director of etf.com. Previously, he was director of ETFs at FactSet Research Systems. Before that, as managing director at BGI, Nadig helped design some of the first ETFs. As co-founder of Cerulli Associates, he conducted some of the earliest research on fee-only financial advisors and the rise of indexing.