Volatility ETFs Often Own All VIX Futures

March 01, 2012

It gets worse. The main index tracked by these funds is the S&P 500 VIX Short-Term Futures Index. This index is 100 percent in the front month only on roll date—most recently, Feb. 15. On every other day in a given month, the fund will be a net seller of the front month and a net buyer of the second month, as it slowly and continuously legs into the next month.

Why is this a problem? Because it’s entirely game-able. Generally, front-running ETF trading is a loser’s game—creations happen in-kind, and are unknown until after the fact.

But in ETNs and swap-based ETFs, the creations and redemptions happen in cash, and there’s no guarantee the counterparties are immediately putting on the underlying hedge.

But here, the issue isn’t flows. For VIX futures, the bulk of trading is being done, not in connection with asset flows, but because of the constant rebalancing of the underlying index. Here’s how this affected, for instance, the weighting of the March contract through the last rebalance across the various ETFs.

Date

Days in Roll Period

Days into Period

Pct in March

Contract

2/24/2012

24

17

70.8%

2/23/2012

24

18

75.0%

2/22/2012

24

19

79.2%

2/21/2012

24

20

83.3%

2/17/2012

24

21

87.5%

2/16/2012

24

22

91.7%

2/15/2012

24

23

95.8%

2/14/2012

24

24

100.0%

2/13/2012

20

1

95.0%

2/10/2012

20

2

90.0%

2/9/2012

20

3

85.0%

2/8/2012

20

4

80.0%

2/7/2012

20

5

75.0%

2/6/2012

20

6

70.0%

2/3/2012

20

7

65.0%

2/2/2012

20

8

60.0%

2/1/2012

20

9

55.0%

1/31/2012

20

10

50.0%

1/30/2012

20

11

45.0%

1/27/2012

20

12

40.0%

1/26/2012

20

13

35.0%

1/25/2012

20

14

30.0%

1/24/2012

20

15

25.0%

1/23/2012

20

16

20.0%

1/20/2012

20

17

15.0%

1/19/2012

20

18

10.0%

1/18/2012

20

19

5.0%

Since ETFs are the primary buyer in the market and their trading is predictable, whoever is on the other side of those transactions is in the catbird’s seat.

They can bid up the price of the second-month futures constantly, and depress the price of the front month the closer it gets to expiration. This creates a kind of inexorable contango maelstrom, which is brutal for long-holders of the ETFs.

But wait, we’re not done. It gets even worse. The snapshot we’re presenting here is from just one day.

 

 

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