Those speculating on a rise in equity market volatility this year have had their moments – notably in April and May, when markets started to worry about a Eurozone sovereign debt crisis.
On 20 May 2010, the spot VIX index (which measures the 30-day implied volatility of the S&P 500 index’s component stocks, as derived from at-the-money options prices) hit a high for the year of 45.79, over double the 2009 end-year level of 21.68. That day saw a 376 point drop in the Dow Jones Industrial Average, the largest absolute decline in that index since February last year.
Strangely enough, although the Eurozone debt crisis shows every sign of intensifying six months later (yesterday Ireland’s five-year CDS spread hit 600 basis points, well above the levels recorded in May, while the country’s ten-year bond now yields over 500 bps more than German bunds for the first time), equity markets sail on unconcerned. At yesterday’s closing level of 18.52, the VIX is now down for the year.
But I’m digressing. One thing that stands out when looking back over the year to date is how badly volatility “trackers” have actually tracked the VIX. See the chart below, where we compare the VIX spot index with the indicative value of VXX, Barclays’ iPath VIX Short-Term Futures ETN. Both price series are rebased to 100 on 31 December.
VXX gives investors an exposure equivalent to a continously rolled VIX futures position (from the one-month into the two-month futures contract), resulting in a constant thirty day maturity profile. Unfortunately, it also means eating a great deal of contango when the VIX futures curve is upward sloping, as it has been throughout this year.
So while the spot VIX index (the red line in the chart) is now just below where it started 2010, VXX (the blue line) has followed a very different trajectory. The ETN lost steadily from January to April, then barely made it back into positive territory for the year in May, even as spot VIX spiked. Since then, it has been a steady and painful decline for VXX’s investors. As at the close of play on 3 November, they were down over 64% for the year.
Record contango in equity market volatility futures has been in the news for a while – we reported on it a month ago, for example. But the devastation being wrought on investors in volatility-linked ETPs (itself highly reminiscent of the shocking performance of oil “trackers” last year) doesn’t seem to be stopping providers from launching them (iPath just launched a new mid-term VStoxx ETN in Europe this week), nor investors from buying them.
iPath’s VXX has over US$1.7 billion in assets, and that’s after losing two-thirds of its value this year. Amazingly, according to the latest National Stock Exchange data for end-October, VXX is the US exchange-traded product with the fifth-largest cash inflows in 2010, having received over US$2.5 billion in new money for the first ten months of the year. For investors, that’s meant throwing good money after bad.
What’s the moral here? For me, the fact that the shape of the futures market curve vastly outweighs the impact of movements in the underlying index in determining the returns of the “tracker” means that these products should be a no-no for most investors. It’s hard enough forecasting how spot volatility might move, let alone predicting levels of futures market contango. And if you want to bet on a short-term rise in volatility, why not use options? One central idea behind volatility ETPs was that they eliminate the time decay problem that you incur when you buy options. Unfortunately, it looks as though the price you pay for doing so is far too high.
Do providers make clear the possible downside involved when buying these products? iPath’s website says that “a direct investment in VIX (commonly referred to as spot VIX) is not possible. The S&P 500 VIX Short-Term Futures Index holds VIX futures contracts, which could involve roll costs and exhibit different risk and return characteristics” (my italics). Does that hint that the VIX might be down 9% in the year while your investment is down 64%? Hardly.
The factsheet for Source’s S&P 500 VIX Futures ETF, which tracks the same index, is more explicit about the risks, if not the scale of the potential losses. It states that “the performance of the reference index is expected to be negative over the longer term. As a result, the Source ETF is not intended as a stand-alone long-term investment.”
If inverse and leveraged exchange-traded funds in the US now come with an SEC-mandated health warning, it’s hard to see why products like VXX (and, by implication, all tracker products based on rolling futures markets contracts) don’t.