North Korean missile launches. Devastating hurricanes and floods slamming into the US. Interest rates appearing to be finally on the rise. President Trump’s uncertain economic and political agenda. A US stock market that has had an unprecedented almost 9-year stratospheric run.
What do the above unnerving economic and non-economic events have in common when concerning the stock market? They can all increase the volatility, or daily up-and-down gyrations of the markets significantly. These movements can wreak having on individual stock prices and the mutual funds or ETF’s you invest in.
Stock market volatility is actually a measurable figure. In the US, stock market volatility is measured by an indicator called the “VIX”, otherwise known as the “fear index” because it tends to increase as stock markets decline. Put as simply as possible, the VIX is the ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index. It is a measurement of the implied volatility of S&P 500 index options. S&P 500 “index options” are a right, but not an obligation, for an investor to buy or sell the S&P 500 index in the future. These VIX futures have been trading on the CBOE since 2004 and mathematically take into account the market prices for all out-of-the-money call and put options in the front and second month expirations (the math is a little heavy for most readers so we will disregard most of the calculations in this article).
Now that we know what it means to invest in the volatility of the market, let’s go buy some VIX when it is down and sell it when it goes higher (or vice-verca if you are interested in shorting volatility) and make lots of money. Sounds as simple as buying shares of Apple or Facebook or a mutual fund, right?
But wait a minute, it’s not that simple.
The actual “VIX” is a mathematical calculation, not a stock, ETF or mutual fund. As such, this “current” volatility cannot be invested in directly. The only way to actually invest in the VIX is through futures or options ETFs on this mathematical calculation. So what’s the problem with investing in futures or options ETFs?
To put simply and rather bluntly, current investment products designed around the VIX are a losing game when it comes to investing in volatility. I like to use investing in volatility to playing blackjack at your favorite casino…….the longer you play, the greater are your odds of losing. Unfortunately the odds at the blackjack table are even better than buying VIX investment products. Impossible you say?
The main reason why VIX investment products will produce a downward-spiraling long-term return is a phenomenon called the “contango trap” in how they are structured. The contango trap occurs in VIX investment ETF products because the futures price curve tends to slope upwards roughly 80% of the time with VIX futures that are based on 30-day maturities. Simply put, the longer-dated futures contracts in the VIX are almost always priced higher than the shorter-dated ones. Therefore, because of the structure of futures-based ETFs (such as VIX futures), fund managers are forced to buy the longer-dated contracts while selling the cheaper, shorter-dated ones (effectively buying high and selling low) when the nearer months are close to expiration. In investment lingo, this is referred to as “negative roll” which invariably creates downward pressure on the VIX ETF prices.
Phew! That’s heavy stuff…….
For example, since the beginning of 2013 the actual VIX has declined by only 25% whereas the most popular VIX ETF, the iPath S&P 500 VIX futures (ticker VXX), has plunged by nearly 96%. In fact, even on a daily basis, VIX ETF products tend to underperform. For example, on August 20, 2015 when the VIX increased by 25% the iPath S&P 500 VIX Futures increased by only 8%. As you can see, based simply on the contango trap itself, VIX ETFs are virtually guaranteed to lose money over the long term.
Outside of the contango trap, there are a few other pitfalls that investors can find themselves facing when investing in VIX ETFs. Due to the daily rebalancing fund manager’s face, VIX ETFs are subject to fairly high management fees. For example, the most popular VIX ETF, the iPath S&P 500 VIX futures has a management fee of almost 1%. Further expenses include futures commissions and trading and licensing fees that can severely eat into investor returns.
However, there are a couple legitimate uses for VIX ETFs. For example, an investor may buy a VIX ETF to hedge against short-term volatility in the market. The VIX tends to spike when the market drops rapidly, making a volatility-tracking ETF a good protective bet against a market crash. The recent Brexit situation offered a good example: An investor could have bought shares of the iPath ETF (VXX) the day before the U.K. vote to protect against a possible market crash if the results favored a “leave.” In this case, the S&P 500 lost 3.6% on the following trading day, while the ETF VXX gained 24% on the spike in volatility. This could have helped investors offset their losses.
However, this type of strategy is a variation of market timing, and is generally not a good idea for retail investors. In fact, any investment with a downward bias — VIX ETFs, leveraged ETFs, and any other futures-based ETF product are generally not a good idea for investors with a long-term mentality.
While instruments like VIX ETFs do indeed serve a purpose in the market, they are best left for professionals and short-term traders. Volatility spikes can certainly cause your stocks and mutual funds to drop in the short term, but having a well-diversified portfolio of rock-solid companies (mainly through mutual funds or ETFs) and mix in some global bonds, real estate, commodities and maybe an alternative investment product or two and your portfolio will produce a reasonably low-risk, good long-term return.
The attached video from The MoneyShow is an excellent 3-minute overview of what the VIX is. Michael Khouw, Managing Director and Head of Equity Derivatives Trading at CRT Capital Group provides a very concise and easy-to-follow interview on the VIX, many of which are explained in this article.