If the past decade is any guide, one of the surest market bets seems to lie not in any particular asset class — stocks, bonds or cash — but in volatility, particularly with the ongoing government shutdown and a possible U.S. default looming.
The growth in volatility investments speaks for itself. The total volume of options written on the CBOE’s Market Volatility Index (VIX) is nearly 30 times higher than when trading started in 2006. Many sophisticated investors now use VIX derivatives to hedge against deep and sudden downward drafts in the market.
Following on this surge, financial services companies have stepped in to offer retail investors VIX Exchange Traded Products (ETPs), which are bought and sold like shares of stock and are open to nearly all investors. Today, there are more than 30 VIX-related ETPs with a total market value of approximately $4 billion.
But these ETP products may be causing more harm than good, says Robert E. Whaley, Valere Blair Potter Professor of Finance at Vanderbilt University’s Owen Graduate School of Management and the original creator of the VIX. In a forthcoming paper for the Journal of Portfolio Management, Whaley demonstrates that these products are “virtually guaranteed to lose money.”
These traded VIX securities are based on a complex futures trading strategy, which requires a daily rebalancing and are subject to various management fees, expenses, and in some cases, forgone interest income. Even the March 23, 2012 prospectus of one of the more popular VIX ETP products, Credit Suisse’s VelocityShares, warns investors:
“The long term expected value of your ETN 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.”
Whaley adds, “What is equally surprising is that most VIX ETP investors cannot gauge the magnitude of the losses they will incur since they do not have access to real-time (or, in many cases, end-of-day) VIX futures prices.”
Yet in spite of the all-but-guaranteed losses — which Whaley estimates at $4 billion and counting so far — investors continue to snap up VIX ETPs.
Whaley’s paper shows that because of the way VIX ETPs are structured using futures contracts, they fall into a “contango trap” in which prices are systematically drawn downward. This happens because the prices of the VIX futures used in the ETPs exceed the spot prices of VIX futures, giving them an upward sloping price curve.
“If a futures price curve (in any market) is consistently upward sloping through time, a long position in the futures will tend to lose money through time relative to a long position in the cash index level,” Whaley writes. “Conversely, if the price curve is downward-sloping, a long futures position will tend to make money relative to a long position in cash.”
Looking at different maturities across the history of VIX futures trading, Whaley found an upward sloping price curve on 1,633 of the 2,021 days, nearly 81% of the VIX futures history. That intensity of the upward sloping curve has only increased since the first VIX ETP was launched in January, 2009.
Consider the performance of iPath’s S&P 500 Short-Term Futures Exchange-Traded Note (VXX). At the time of Whaley’s paper, VXX had lost 93.6% of its value since inception, and yet it still accounted for 56.4% of ETP investments tied to VIX. Whaley says many institutional investors have begun to make money by being on the other side of short-term VIX ETP trades. The inverse short-term ETP known by its ticker symbol, XIV, has experienced a 6% annualized return between December 2005 through March 2012.
For those considering VIX ETPs as a long-term holding, Whaley offers two suggestions: First, buy products focused on the mid-term, not short-term VIX futures. Second, consider only VIX ETPs that provide interest accrual.
“The risk-free return on the capital tied up in the VIX ETPs properly belong to the investor,” Whaley writes. “When the economy fully recovers and interest rates return to more normal levels, this income may amount to several hundred basis points a year.”