Hedging The Unexpected: Funds Try Mimicking The VIX

January 23, 2009

ETNs and ETFs on the way to play off stock volatility aren't for long-term investors. So how well will they really work for traders?


This is a good-news, bad-news type of story.

On the one hand, volatility-tracking index-based products are on the way. So far, two iPath exchange-traded notes have shown up in Securities and Exchange Commission filings. And we're hearing that some exchange-traded fund providers are working on launching similar types of portfolios. (See related story here.)

If you're really obsessed these days with market volatility, then more ways to play market gyrations might seem like a good idea.

But that's not necessarily true in all cases. Just ask Srikant Dash, Standard & Poor's head of global research and design. The index provider has just launched a series of benchmarks targeting U.S. volatility markets. (See related article here.)

"It's important to note that these indexes are designed as trading tools in anticipation of sharp movements in markets. These indexes cater to those types of traders," said Dash.

He says these new VIX-tracking indexes aren't designed with the average investor in mind. He won't talk specifically about Barclays' upcoming ETNs. Still, such warnings are likely to pertain to the ETNs and ETFs on the drawing boards since S&P believes its new indexes are the first of their kind in the U.S.

(The only other volatility index we've heard about in the U.S. tracks junk bonds. And it uses futures contracts, the same as S&P's VIX series.)

More Of An Art? 

But whether you're a long-term investor or short-term market timer, reliance on an index-based product to track the CBOE VIX can't be considered an exact science.

"While the VIX is very well known, it's very difficult to replicate exactly," said Dash. "The new S&P volatility indexes represent values of VIX futures contracts, not the VIX numbers that people are familiar with exactly."

According to S&P research, the new volatility indexes it has created should show about an 88% correlation over time with headline spot VIX numbers.

That's enough, says Dash, to incorporate all of the desirable effects of the VIX that traders need. He adds that the S&P benchmarks should have a negative correlation to the S&P 500 of some 76%. That would be almost dead-on with the VIX itself, which has shown a negative 75% correlation to the same blue chip stock benchmark.

(See related S&P report on volatility as an asset class and backtested data on the new indexes in IU.com's Research Section here.)

Don Fishback, noted options trading consultant and analyst, says that he sees problems on the horizon with the new funds tracking the VIX.

"Although correlations over longer periods will probably be around 88%, those relationships between futures prices and actual VIX prices drop significantly the precise moment you need the hedge most," he said.

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