Contango in the VIX futures market has hit a four-year high, presenting a huge negative roll yield for investors in VIX tracker products like ETFs and ETNs.
VIX measures the implied volatility of 30-day options on the S&P 500 index of US equities, while VIX futures reflect forward expectations of the VIX (for example, a December 2010 VIX futures contract represents a view of what 30-day implied volatility will be on the December expiration date).
Volatility ETFs and ETNs such as the S&P 500 VIX Futures Source ETF (LSE: VIXS) and the iPath S&P 500 VIX Short-Term and Medium-Term Futures ETNs (NYSE Arca: VXX, VXZ), (LSE: VXIS, VXIM), offer investors exposure to VIX futures contracts by maintaining a constant maturity exposure. In the case of ETFs and ETNs tracking the S&P 500 short-term futures index, this is achieved by the daily rolling of a proportion of the trackers’ one-month futures contracts into second month contracts, so as to achieve a constant one-month average maturity.
The medium-term index measures the return from a rolling long position in the fourth, fifth, sixth, and seventh month VIX futures contracts, with a constant five-month average maturity.
Based on closing prices from the Chicago Board Options Exchange (CBOE) yesterday, October 11, the price ratio between one-month and three-month VIX futures (often referred to by traders as the VIXVXV ratio) settled at a four-year low of 0.7874.
The ratio between first (October 2010) and second month (November 2010) VIX futures at the CBOE at yesterday’s close was 0.8486.
For investors in funds and notes tracking the short-term VIX futures index, this contango represents a negative roll yield of over 15% per month, assuming no change in the shape or level of the futures curve (contango describes an upward-sloping forward or futures market curve, with longer-dated contracts trading at a price premium to shorter-dated ones). Over a year, such a futures contango would swallow over 86% of an investor’s initial investment, again assuming no change in the VIX futures curve.
Since its launch on June 21 this year, the NAV of the S&P 500 VIX Futures Source ETF, which has US$49 million under management, has declined by over 40%, reflecting both a decline in VIX levels and persistent futures market contango.
The US-listed iPath S&P 500 VIX short-term futures ETN (VXX) has fallen by over 55% this year, although it continues to attract investor cash: it currently has over US$2.1 billion in issue, as well as having received over US$2.3 billion in net new investor funds by the end of September this year, according to National Stock Exchange data. This makes VXX the seventh-largest recipient of cash flow in 2010 of all US-listed exchange-traded products.
One market observer, Chris Cole, managing partner of Artemis Capital Management, points out in his latest investor newsletter that the current futures market contango may reflect a likely imminent move higher in “spot” (near-term) equity market volatility, which would likely lead to a decline in the negative roll yield.
According to research by Barclays Capital, over an 18-year period the median negative roll yield for the S&P VIX short-term futures index has been 10% per month during low volatility periods, while during times of crisis it can spike to positive values of over 20% (reflecting a shift in the VIX futures curve to backwardation). For the whole period the median roll yield for the short-term futures index is a negative 3% per month.
These considerations, however, mean that volatility trackers should probably be seen purely as short-term trading vehicles, say many experts. According to Bill Luby, author of the “VIX and More” blog, as a result of these futures curve term structure effects, “neither volatility ETPs such as VXX, nor leveraged ETFs, are advisable vehicles for the long-term buy-and-hold investor.”