Swedroe: Volatility & Corrosive Contango

Volatility ETFs have their uses and users, but just how do they work?

The presence of regularly occurring anomalies in conventional economic theory led to the development of the field of behavioral finance, and the volatility anomaly is one that deserves some special attention.

Anomalies directly violate modern financial and economic theories, which assume rational and logical behavior. We now have a laundry list of anomalies, including momentum and the poor performance of stocks that exhibit lotterylike distributions—initial public offerings, penny stocks, small-growth stocks and stocks in bankruptcy.

But, as I said, there’s another anomaly that belongs on the list—the popularity of volatility-based investment products.

Exchange-traded products (ETPs) linked to the CBOE Market Volatility Index (VIX) were launched in January 2009. There are now more than 30 ETPs with a market value of about $4 billion, generating daily trading volume in excess of $800 million.

You might wonder why there’s all this interest, when the March 23, 2012 prospectus of VelocityShares, the exchange-traded notes (ETN) issued by Credit Suisse AG states: “The long term expected value of your ETNs is zero. If you hold your ETNs as a long- term investment, it is likely that you will lose all or a substantial portion of your investment.”

In case anyone didn’t know, these securities are not suitable buy-and-hold investments.

So what explains the all the interest in these products? Why are they so popular? We know why the purveyors of the products create them—the annual fees range from 0.85 to 1.65 percent, or $85 to $165 for each $10,000 invested—but why do investors purchase them when they’re more or less guaranteed to lose money over time?

Robert Whaley, author of the paper “Trading Volatility: At What Cost?,” sought the answers to those questions.

Before digging into the findings, it’s important to understand that ETPs are not investments in the Chicago Board of Exchange (CBOE) volatility index called the VIX, which was launched in 1993.

As Whaley explains: “The VIX itself isn’t a traded security. VIX ETPs are traded securities created from complicated VIX futures trading strategies which demand daily rebalancing and are subject to a host of management fees and expenses including futures commissions and trading fees, licensing fees, and, in some cases, foregone interest income.”

What’s The Attraction?

The VIX measures investor anxiety, spiking during periods of uncertainty and turmoil, and hovering at low levels during more quiet periods. The purchase of ETPs provides investors with exposure to volatility, providing, in theory, an effective hedge against spikes in volatility caused by events that increase uncertainty and drive down stock prices.

While investors can directly trade the futures themselves, many institutions, such as pension funds and endowments, are barred from buying futures and option contracts by charter. (Institutions account for about 30 percent assets in ETPs.)

In addition, most retail investors are simply too small to trade in the derivatives market or they lack the necessary trading sophistication. ETPs fill the void by providing access to volatility trading through the stock market. That’s the attraction.

Performance

Whaley found that the correlation of returns between the products and their benchmark indices was high for all the products, on the order of -0.78. Thus, holding other factors constant, the volatility indexes are effective at diversifying stock portfolio risk. That’s the good news. The bad news is that all else isn’t equal. Correlations aren’t the only things that matter.

Whaley found that since inception, the VIX Short Term Total Return Futures Index fell by more than 93 percent! The compound annual growth rate was -34.8 percent. Even worse is the return performance of the VelocityShares Daily 2X VIX Short Term ETN (TVIX), with a holding period return of –99.96 percent and a compound annual return of –71.7 percent. He noted this return was eerily consistent with the Credit Suisse warning about its VelocityShares product.

It’s All About Contango

What caused the loss of almost 100 percent of the investment in volatility products? The culprit is the contango in the VIX futures market. Contango occurs when the futures price curve is upward sloping. (When the futures prices curve is downward sloping, the market is in backwardation.)

For example, as I write this on Feb. 25, while the VIX closed at 13.67 on the CBOE, the nearest contract (settlement on March 18) was trading at 14.87. That’s a premium of 8.8 percent for basically just three weeks. The next two-month contracts were trading at 15.3 and 15.94, nonannualized premiums of 11.9 percent and 16.6 percent, respectively.

Those prices translate into huge annualized premiums. This is important because the volatility futures price curve has been upward sloping more than 80 percent of the time. Whaley also found that while the VIX futures term structure is typically in contango, it’s much more steeply sloped for shorter maturities than for longer maturities.

Thus, we have our anomaly. As Whaley notes: “Amazingly, in spite of the fact that holders of ETPs linked to the S&P 500 VIX futures short-term indexes have chalked up more than $4 billion in losses since product inception, the market continues to grow.”

The only explanations for this phenomenon seem to be that either investors are unaware of the size of their losses, and/or they’re irrational, as investments in these products are likely to lose money.

That leaves us with one other issue to address: If the holders of VIX ETPs are losing money, is it possible to make money by being on the other side of the trade?

Whaley concluded that it is possible.

But the problems are that, to go short, you must borrow the securities (so you can sell them); and these securities are hard to borrow. Also, rebate rates are often thousands of basis points below the general collateral rate. Another alternative is to buy an inverse ETP.

The iPath Inverse S&P 500 VIX Short-Term Futures ETN (XXV) experienced a 6.0 percent annualized return over the period from December 2005 through March 2012. During this period, the S&P 500 itself returned 4.1 percent. However, it’s important to note that the returns of inverse VIX ETPs are highly positively correlated with stock returns. Thus, they don’t provide much in the way of a diversification benefit.

Whaley offered two suggestions for those considering VIX ETPs as long-term holdings. The first is to buy VIX ETPs that are based on the VIX midterm rather than the VIX short-term futures index. As we discussed, the term structure of VIX futures prices is much flatter in the region at the Mid-Term index’s (MT) five-month month maturity than at the Short-Term index’s one-month maturity.

Over the six-year period in which S&P reported futures index returns, the holding period return of the Mid-Term index was 5.9 percent compared with the Short Term index return of –93.9 percent. At the same time, the Mid Term index returns are almost as negatively correlated with stock returns (–0.77) as the Short Term index returns (–0.78), so there is no loss in diversification effectiveness.

Second, holding other factors constant, consider only VIX ETPs that provide interest accrual, whether it is accomplished by benchmarking to the Total Return indexes [e.g., iPath S&P 500 VIX Short-Term Futures ETN (VXX | A-54] or promising the return of the Excess Return indexes plus an explicit interest accrual [e.g., VelocityShares VIX Short Term ETN (VIIX | B-54)]. The risk-free return on the capital tied up in VIX ETPs properly belongs to the investor.

And while this currently doesn’t matter with interest rates at effectively zero, when interest rates return to more normal levels, this income may amount to several hundred basis points a year.

Larry Swedroe is director of Research for the BAM Alliance, which is part of St. Louis-based Buckingham Asset Management.