JPMorgan's notes linked to Strategic Volatility index seek to enhance long volatility exposure

By Emma Trincal

New York, April 26 - JPMorgan Chase & Co.'s 0% return notes due May 13, 2013 linked to the J.P. Morgan Strategic Volatility index are designed for investors seeking a long exposure to volatility while reducing some of the costs associated with VIX futures contracts, according to an FWP filing with the Securities and Exchange Commission.

Sources said that the underlying proprietary index designed by JPMorgan is not the only one aiming to offset those costs and to help them get an optimal exposure to this asset class.

"But it's certainly one approach," a market participant said.

"It's one way to reduce the cost of rolling VIX futures contracts," he said, adding that getting long volatility exposure can end up being costly for the investors over the long term due to contango.

When the market for VIX futures contracts is in contango, the price of VIX futures contracts will decrease as the contracts move nearer to maturity, according to the prospectus. Under this scenario, the return from the long exposure to the VIX will decline due to the added cost of rolling the contracts.

That is because the VIX futures contract with a later expiration must be bought at a higher price than the price of the contract with an earlier expiration, which has to be sold, hence creating a negative roll yield.

Contango

In a contango scenario, the J.P. Morgan Strategic Volatility index provides long exposure to VIX futures at the second month point and aims to offset, or even profit from, the negative roll yield associated with long VIX positions by activating a short position in VIX futures at the first month during certain market conditions.

"There are other ways to address this contango issue," the market participant said.

"One way is the VIX dynamic volatility index that considers the steepness of the curve and allocates between positions to reduce the rolling cost.

"Others use dynamic allocations between cash, equity and volatility. That's the Dynamic Veqtor index idea.

"Finally, you have indexes like the Nomura Voltage launched last year that vary the allocation to the VIX futures based on the volatility of volatility. Sometimes the index is not allocated to volatility at all. It only allocates to it when the VIX increases. But I haven't seen it in the U.S., although the JPMorgan Volatility index is in some kind of similar approach."

Uses

While being long equity volatility is not exactly the same as shorting equity, one of the uses of a long exposure to VIX futures is to hedge the market risk of a long equity position, the market participant said, due to the negative correlation between volatility and stock returns.

"It gives your overall portfolio an additional hedge," he said.

"It depends on your portfolio allocation of course. If you're mostly fixed income, it wouldn't be suitable.

"But having some volatility exposure in general in your portfolio makes sense."

The notes can also be used as an alternative to other instruments such as exchange-traded funds, which have been known to be adversely impacted by contango in the way they track VIX futures. The contango effect worsens when the investor has a long term exposure to volatility.

"You can use an ETF but it should be more tactical. Those VIX ETFs are short-term oriented. You should use it when you're certain about your timing," the market participant said.

"If you're not sure about the future direction of volatility, then the JP Morgan index makes sense because their algorithm is taking those moves into consideration," he said.

A structurer said that the algorithm was conceived to adjust to changing market conditions as reflected by the steepness of the volatility curve and the direction of the VIX futures.

"If volatility is on the rise, you get the long exposure to the first month. If volatility is going to decline, you short the first month," he said.

"You short the most expensive contract and you buy the cheaper one, picking up the roll cost.

"They change the allocation so that your weighted average maturity remains the same."

The short exposure will vary between 0% and 100%, according to the prospectus. The index is rules-based and rebalanced daily.

This structurer said that investors could replicate the strategy themselves using exchange-traded funds, but it would require a hands-on approach.

"The ETF provides investors with the tools to do it themselves," he said.

"The index offers the strategy in a package. They take the decision-making out from you."

Asset class

Matt Medeiros, president and chief executive officer at the Institute for Wealth Management, said that he has actively used volatility in the management of his overall portfolio.

"We consider volatility as an asset class. It provides a very consistent, non-correlated return," he said.

"I like the idea of those notes. I like the structure. Having the ability to implement a short position even when the long volatility hasn't changed has been a winning strategy for us.

"If volatility hasn't changed for a period of time, the decay of those long volatility contracts can be captured on the short position, providing a nice alpha return on the portfolio.

"And then you have the compounding factor. You can generate growth because as volatility trends, one position or the other will grow larger and in turn benefit more from further moves in the same direction.

"Volatility is a sophisticated asset class that as a risk manager it's important to understand."

Outperforming the S&P

The JPMorgan index generated an annualized rate of return of 38.97% versus a 1.83% annualized loss for the S&P 500, according to hypothetical historical returns from September 2006 to September 2011 included in the prospectus.

"It was a period of extreme volatility changes," the market participant said, calling to mind the low volatility in 2007 prior to the financial panic of 2008.

"It's been quite a volatile ride. The question of course is would it perform the same in an uptrending market?"

The index incorporates a 0.75% per annum fee as well as additional deductions related to the notional rebalancing of the VIX futures contracts for an amount comprised between 0.2% and 0.5% per day and applied to the notional amount of the contracts traded as well as to the amount of the change in the short position, according to the prospectus.

"It's not really that much if you consider the slippage you're having to deal with when trading volatility," the market participant.

Slippage means a wide bid/ask spread.

"[The spread] can be as high as a couple of percentage points depending on the liquidity. So from that perspective, the rebalancing fee is reasonable. Also, not all the trades can be done on the closing price. Sometimes you have to do it before, sometimes the next day. That adds to the cost," he said.

A cost is relative and depends on what an investor is trying to achieve, the structurer said.

"The trading costs involved with the hedging of this strategy are factored into the notes.

"It's a good solution if you don't want to do it yourself. As with any investments, though, investors have to look at the costs carefully."

J.P. Morgan Securities LLC is the agent.

The notes will price Friday and settle May 4.

The Cusip number is 48125VWL0.

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