Friday, 6 July 2012

Investing in Fear: Part Two

In Investing in Fear: Part One we discussed what the VIX Index is and how its tendency to move in the opposite direction to equity markets increasingly attracts a greater number of investors.

Volatility investing used to be a privilege only afforded to the highly sophisticated investor.  However, as the number of investors keen to exploit the VIX’s hedging capability increased, so opportunities for the retail sector began to emerge.  But just as it has become easier to invest in the ‘Fear Index’, it has also become alarmingly costly. So much so that hedging using VIX, we believe, should not be considered a ‘buy and hold’ strategy.

As the chart below illustrates, if you had invested $100 into one of the biggest volatility ‘ETNs’ (an instrument which you can buy and sell during market hours) on the day it was launched in 2009, today your investment would be worth around $4.41! 

Source: Brewin Dolphin/DataStream

 This phenomenon of hemorrhaging capital is driven by the structural features of the VIX derivatives market.

Volatility funds cannot invest in the VIX Index outright as they would be able to do with gold or shares. Most volatility ETFs use VIX ‘futures’ contracts to replicate the performance profile of the VIX Index. These are agreements that reflect future levels of volatility, as anticipated by the market.  For example, the July 2012 VIX futures indicate the expected volatility in the S&P 500 for the 30 days following the contract expiration.

When markets are calm, VIX futures normally trade above the prevailing level of the VIX Index. Longer-dated contracts command higher premiums because the further we look into the future the less certain we can be about it. During periods of acute volatility (typically when the equity market falls fast) the VIX Index soars but the futures’ prices usually rise more slowly, reflecting the markets’ prediction of a return to ‘normality’. Hence futures will trade at a discount to the VIX Index.

However, irrespective of whether futures contracts are trading at a premium or discount, as the contracts near expiry the futures’ prices will converge on the VIX Index.

Volatility ETFs maintain exposure to volatility as an asset class by selling expiring VIX futures and buying longer dated ones. ETF managers tend to pay a higher price for longer dated futures because, historically, VIX futures have traded at a higher price than the VIX Index (70% of the time in the last five years). They then must sell them as they near expiry at, typically, lower prices (recalling that futures’ prices converge on the ‘lower’ VIX Index). 

The ETF manager repeats these transactions on a frequent basis to maintain continuous VIX exposure, making small losses more often than gains. These losses are known as ‘negative carry’ and, when incurred over prolonged periods, result in the ETF slowly but surely bleeding its capital and, therein reducing its potency as an efficient hedge.

On the upside, the volatility ETF makes money when the VIX spikes, as prices of the expiring contracts (that ones that are sold by the ETF) converge with the elevated level of the VIX.

The chart below shows the persistency of negative carry. Compounding the issue is the fact that more recently, it seems that the negative carry has been elevated by the increasing demand from the growing number of volatility ETFs (such as the iPath VIX ETF whose assets are shown on the graph).  The result is that the investor ends up paying more for less.

Source: Brewin Dolphin/DataStream
Shakhista Mukhamedova
Analyst - Fund Research

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