Pair Of VIX-Tracking ETNs On The Way

January 21, 2009

Barclays Capital has filed to launch a pair of ETNs that aim to track the Chicago Board Options Exchange's Volatility Index.


Hedging stock market turbulence by trading options on volatility indexes has grown in the past two years to become a popular strategy with institutional investors.

But barring some unforeseen complication, individual investors and their professional advisors should soon be able to do much the same in a seemingly less complicated and affordable manner.

Barclays Capital, the unit of London-based Barclays PLC and a sibling of Barclays Global Investors, has filed to launch a pair of ETNs that aim to track the Chicago Board Options Exchange's Volatility Index.

There's no word yet when the iPath S&P 500 VIX Short-Term Futures and the iPath S&P 500 VIX Mid-Term Futures ETNs will debut. But given the lead time of the filing—it was dated almost a month ago and referenced an earlier prospectus from last August—it's likely to expect the new ETFs to launch shortly, perhaps within weeks rather than months.

Messages left with representatives of Barclays Capital and the CBOE late Tuesday weren't immediately returned. 

According to the filings, the new VIX ETNs will charge net fees to investors of 0.89% per year and trade on the NYSE Arca exchange. Both ETNs will continuously roll over contracts. The shorter-termed iPath will trade one- and two-month VIX futures. The benchmark's goal is to maintain a weighted average of one month, according to the prospectus.

Planned Rotation 

The longer-termed iPath will rotate among four-, five-, six- and seven-month contracts as they come due, shooting for a weighted average maturity of five months.

The VIX Index is calculated based on the prices of put and call options on the S&P 500. "Futures on the VIX Index allow investors the ability to invest in forward volatility based on their view of the future direction or movement of the VIX Index," noted the filing.

The ETNs' underlying benchmarks were created by Standard & Poor's last month. The filing points to limited backtested performance data. Also, it notes that VIX futures have only traded freely since March 2004, "and not all futures of all relevant maturities have traded at all times since that data."

During a two-year period ended in late December 2007, backtested performance graphs included in the documents show the short-term VIX benchmark would've doubled in value. In the same time frame, the S&P 500 Total Return Index actually lost value.

But when the return period is extended to late December 2008, the VIX's value shot up to around a 200% increase. The S&P 500 fell even more.

Four years ago, the CBOE first started offering trading on futures contracts tied to the VIX. That gave investors a new tool to manage risk by hedging the S&P 500's volatility. Two years later, options on the benchmark opened with much fanfare, proving to be even more popular and significantly broadening the VIX's reach with professional and more-sophisticated investors.

Although there is no economic return component to the VIX—it is simply a measure of the implied volatility of S&P 500 index options—it has proved to have a role in portfolio construction because it has such a strong negative correlation with stocks.

In an interview with last summer, CBOE's Matt Moran pointed out that VIX options have been the most popular product in the exchange's history. In fact, he described VIX investing as creating an entirely new asset class, raising the question of whether such strategies could be properly defined by traditional methods of analysis.


"One of the really compelling features of the VIX is that it tends to explode on the upside when the stock market goes down. For example, on February 27 of 2007, the S&P 500 was down 3.5%, and the VIX shot up by 64% in one day. So, in some ways, it's similar to catastrophe insurance," said Moran.

When options on VIX first started being offered in the U.S., big international banks were prime participants, he added. Those large financial institutions were already experienced in trading complex utility swaps over the counter.

"They wanted to hedge their portfolios, and they used VIX futures and options to do so. That was one of the big initial customer segments," said Moran.

Hedge funds also have become big users of VIX options. "Hedge funds love anything that moves, and VIX is one of the fastest-moving products out there, so they are very opportunistic in their trading," said Moran.

In fact, when asked by Heather Bell if he expected an exchange- traded fund tracking the VIX to launch at some point, the CBOE executive observed that operational questions remained.

"Goldman Sachs and others have come out with products such as certificates that have been tied to the VIX. There are futures and options, and if the demand continues, I would not be surprised if someone comes out with some creative solutions," said Moran.

Going the ETN route—using notes in such an obscure market—seems to have proved the key to delivering an investable portfolio accessible on a daily basis to retail markets.

Logical Avenues 

While it might be a logical way to realistically open such avenues to individual investors, ETNs do hold certain risks that ETFs typically don't present.

One is taxes. The notes held by the new iPath VIX ETNs should be considered as prepaid contracts, says Barclays Capital in its filing. Right now, those types of contracts receive favorable tax treatment in that capital gains don't have to be paid until redemption or maturity.

But the Internal Revenue Service ruled in late 2007 that contracts held by currency ETNs weren't subject to the same tax treatment. It's considering related issues with other types of ETFs, although no new rules have been issued. 

Also, since the iPaths will be issued as notes, they'll essentially represent unsecured debt for anyone purchasing the ETNs. That's typical for such investment vehicles. But with the market's ongoing turbulence, it's something to keep in mind.

On Tuesday, shares of the big U.K.-based Barclays Plc tumbled 17% on the London Stock Exchange. Since Monday, Barclays Plc has lost nearly 60% of its value. A report in the British paper The Independent says the bank is under intense pressure to move up its latest earnings call, possibly as soon as this week, from mid-February, to reassure investors. The story also noted that last week Barclays issued a statement saying that its profits for last year would turn out to be well ahead of forecasts by analysts.



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