How To Use Volatility ETFs

January 05, 2018

2017 will go down in stock market history for its volatility. Not because there was a lot of it―quite the opposite. The year featured one of the least-volatile stock markets in history, including a maximum drawdown of 2.8% (the smallest in history) and an average absolute daily price change of 0.3% (also the smallest in history).

The most famous gauge of U.S. stock market volatility, the Cboe Volatility Index—VIX for short—reflected the unusually tranquil backdrop of 2017. It fell to as little as 8.56, the lowest level ever for the gauge, which had broken below 9 only once before in its history.

The VIX doesn't measure actual, realized volatility. It measures what is known as implied volatility, which is calculated based on the price of near-term S&P 500 Index options. In other words, the VIX measures the market's best expectation of volatility over the next 30 days.

The VIX is low now, but it won't always be. The index has a tendency to revert to the mean. When the stock market sells off and expectations of volatility rise again―as they inevitably will―the VIX will spike. The long-term average for the gauge is 19.4, which, as of this writing, is double the current level of the index.

Given the high likelihood that the VIX will jump significantly from here at some point, you may be wondering whether there is some way to buy the index and profit from any potential upswing in it.

VIX Futures Explained

Unfortunately, the VIX itself―also known as spot VIX―is uninvestable: There's no way to buy or sell the popular gauge, because the underlying portfolio of options that the index measures is constantly changing. However, there are financial products closely tied to movements in the index.

VIX futures contracts allow traders to bet on what value the index will be at some date in the future. Cboe lists a number of weekly and monthly VIX futures contracts whose values fluctuate based on where traders believe the level of the VIX will be at the contract's expiration date.

The value of VIX futures tends to converge with spot VIX as a contract's expiration nears, but can deviate significantly from spot for contracts where expiration is far in the future.

For example, as of this writing on Jan. 3, VIX futures that expire on Jan. 10 were trading at 10, modestly above the spot level of 9.15. However, VIX futures that expire on Sept. 19, 2018 were trading around 16, significantly above current spot levels.

 

Source: Bloomberg

 

When the spot VIX is low, VIX futures typically trade at a premium (also known as contango). When spot VIX is high, the futures tend to trade at a discount (also known as backwardation) as traders anticipate an eventual reversion to the mean.

VIX ETFs

VIX futures aren't the only way to get exposure to the volatility index. Like many financial assets, VIX futures have been packaged into ETF wrappers in various ways, making it easier for investors and speculators to bet on volatility.

The $875 million iPath S&P 500 VIX Short-Term Futures ETN (VXX), launched in 2009, was the first product to offer exposure to VIX futures. It holds futures contracts with an average maturity of one month.

 

On a day-to-day basis, the correlation between VXX and spot VIX is strong. They largely move in the same direction on any given day, but the magnitude of moves is usually larger for spot VIX than VXX.

Longer term, there's a big divergence in the performance of spot VIX and futures-tracking products like VXX. Because futures contracts expire, VXX has to roll its futures position into later-dated contracts each month. When the futures curve is in contango (as it has been most of the time historically), with each subsequent futures contract trading at a premium to the last, VXX can afford fewer and fewer contracts over time.

Also known as a "roll cost," this reduces returns significantly over the long term. For example, since its inception nine years ago, VXX is down a whopping 99.97%―that's not a typo.

 

VXX Performance Since Inception

 

For comparison, spot VIX is down 59.3% in that same time period, while the value of front-month VIX futures is down 53.5%.

Other Long VIX ETFs

VXX is one of almost two dozen exchange-traded volatility products on the market. There are others offering nearly the same exposure, like the $131 million ProShares VIX Short-Term Futures ETF (VIXY).

Then there are products that add leverage to the mix. The $385 million ProShares Ultra VIX Short-Term Futures ETF (UVXY) and the $200 million VelocityShares Daily 2x VIX Short-Term ETN (TVIX) both offer 2x leveraged exposure to VIX futures with a weighted average maturity of one month.

Unsurprisingly, their long-term performance has been abysmal, with losses of almost 100% for each product since inception.  

There are other products that attempt to mitigate the poor performance of the aforementioned short-term VIX ETFs by holding midterm futures. The $39 million iPath S&P 500 VIX Mid-Term Futures ETN (VXZ), which holds futures with a weighted-average maturity of five months, takes that approach. Holding futures in the middle of the futures curve has historically reduced roll costs, but not by much. VXZ is still down 95.8% in the past nine years.

Shorting The VIX

Taking an altogether different tack are short VIX products. The $1.2 billion VelocityShares Daily Inverse VIX Short-Term ETN (XIV) and the $826 million ProShares Short VIX Short-Term Futures ETF (SVXY) capitalize on the same futures curve dynamics that hurt their long-VIX counterparts.

XIV and SVXY short VIX futures that have an average of one month until expiration, a strategy that’s been wildly successful in today's low-volatility environment. The two ETFs gained more than 180% each in 2017, and are up more than 600% over the past five years.

 

XIV 5-Year Performance

 

That said, those gains haven't necessarily come easily. Shorting something as volatile as VIX futures can be painful on any given day when the market sells off and implied volatility spikes. In August 2015, when the stock market sold off sharply over a three-day span, XIV and SVXY lost more than half their value.

In mid-2011, XIV dropped almost 75% over two months (SVXY hadn't launched yet). Neither XIV nor SVXY were around during the financial crisis of 10 years ago, but if they were, they would’ve lost about 92% peak-to-trough, according to backtested data.

Using Volatility ETFs

VIX ETFs aren't for everyone. They're certainly good products for speculators who can stomach the huge swings in the underlying VIX futures. Both short and long VIX ETFs can be lucrative for anyone who can time the movements in the VIX accurately.

For long-term investors, the evidence is clear that long VIX ETFs like VXX aren't fit for a portfolio. Short VIX products, which have performed phenomenally ever since they came to market, may have a place in a portfolio as a small “alternatives” position for aggressive investors.

Harvard's endowment recently revealed that it held a small position in SVXY, according to filings with the SEC.

Finally, there's the option to use volatility ETFs as a hedge. For example, VXX could be used to hedge against a market downturn. If the market declined, VXX would spike, offsetting losses in a broad market equity portfolio.

Such a hedge would be expensive―VXX has an annual fee of 0.89%, and, as stated previously, tends to lose a lot of its value over time due to roll costs. A volatility hedge would have to be timed well to prove fruitful, and requires at least some degree of speculation on the part of the investor.

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