Low volatility revives interest in VIX ETNs for directional bets, hedges

Emma Trincal

New York, March 23 - Investors are expressing a growing interest in volatility-based exchange-traded notes with the current rally, sources said. But they also warned that buying volatility futures contracts wrapped in a note is not for the faint of heart.

"Based on the growth of the VIX exchange-traded products market, it appears that investors are becoming better acquainted with volatility and the role it plays in a portfolio. Apparently, market participants are more actively managing volatility," said Will Lloyd, managing director at VelocityShares LLC.

Volatility-based ETNs offer exposure to the performance of the S&P 500 VIX Short-Term Futures index as well as the S&P 500 VIX Mid-Term Futures index.

Volatility can only be traded in derivatives contracts. The CBOE Volatility index, or VIX, itself is not investable.

"The bulk of the growth is in long products, not as much in inverse VIX ETNs. The S&P has rallied at record levels. VIX is very depressed. There's a lot of interest in long positions," a market participant said.

The VIX has an inverse correlation to U.S. equity markets. When equity markets rally, the VIX decreases as it is the case now, sources said.

The VIX, currently trading slightly below 15, is at its lowest level since April 2011. It is down 65% since its last peak in September at 43. The so-called fear index reached its high in October 2008 in the immediate aftermath of the Lehman Brothers collapse.

Uses

Investors seek VIX ETNs for two main reasons, said Tim Edwards, vice president, Investor Solutions at Barclays.

"Investors sometimes use these products as vehicles to express a view that they expect volatility to go up in the short term," he said.

"There is also interest from investors who are taking positions in the volatility markets in order to hedge a position in the U.S. equity markets."

Examples of recent VIX-based offerings include Credit Suisse AG, Nassau Branch's VelocityShares Daily Long VIX Short-Term ETNs, VelocityShares Daily 2x VIX Short-Term ETNs and VelocityShares Daily Inverse VIX Short-Term ETNs.

Most of the products hitting the market have a long exposure to the VIX and use the S&P 500 VIX Short-Term Futures index rather than the mid-term version, according to data compiled by Prospect News.

"Some use it in a tactical way, betting on the appreciation of the VIX. Others use it to hedge their portfolio," the market participant said. "Either way, they're initiating a long position."

"Historically the S&P 500 VIX Short-Term Futures index has more closely tracked spot VIX than the S&P 500 VIX Mid-Term Futures index, and we believe this is why the products based on the short-term futures index have attracted more assets," Lloyd said.

No novelties

A sellsider also noted that the S&P 500 VIX Short-Term Futures index has been the more popular of the two indexes because of its higher beta to the VIX index.

"It's a more capital-efficient way to take a volatility position," he said.

While demand for volatility-based ETNs is on the rise, sources noted that innovation has not been as great this year as in previous years.

The Chicago Board Options Exchange announced on March 14 the creation of a new index, the CBOE "VIX of VIX" index, designed to track the volatility of the VIX index.

But a spokesman at CBOE said that "it's just a benchmark" and "there are no plans right now to launch futures or options on it."

The market participant said that he has not seen any new exchange-traded products related to the VIX this year.

"The inflows have been in existing products," he noted.

"We've seen an increased interest recently in dynamic products, such as the Barclays [Bank plc] ETN+ S&P Veqtor ETN and the iPath S&P 500 Dynamic VIX ETN," said Edwards.

The Veqtor ETN allocates between volatility, cash and equity, and the Dynamic VIX ETN allocates between the different parts of the volatility curve, he said.

"Both products were launched some time after VXX and VXZ with the intention of providing a more efficient access to common strategies in the equity and equity volatility markets," he added.

"VXX" is the NYSE Arca symbol for the iPath S&P 500 VIX Short-Term Futures ETNs.

The symbol "VXZ" designates the iPath S&P 500 VIX Mid-Term Futures ETNs.

Contango

Some sources pointed to the very speculative nature of volatility-based investments.

An example is the performance of the iPath S&P 500 VIX Short-Term Futures ETNs due Jan. 30, 2019.

Barclays earlier this month priced an additional $20 billion of the product, according to a 424B2 filing with the Securities and Exchange Commission.

However the prospectus stated that the actual aggregate market price was only $1.1 million. The ETNs were first issued in February 2009.

One of the risks involved with those products is contango, a market condition that erodes performance.

"In the case of the VXX, contango definitely contributed to the poor performance," a source said.

Futures contracts are rolled from one month to the next. The market is in contango when the cost of rolling increases because the front contract - which must be sold - is priced lower than the farther dated contract that is to be purchased. The so-called "negative roll yield" reduces returns.

A structurer said that he is wary of the way volatility futures contracts behave.

"There is a steep contango with VIX futures," he said. "When you buy on the front end of the curve, you'll experience contango. It's a quite speculative instrument.

"If the market crashes 20% and you're long VIX, you may triple or quadruple your return, but it's only short term and when the market recovers, the VIX drops. It's a mean reversing structure.

"So over the short term you may perform well. But if you do a buy and hold, you have to look at it carefully and know what you're investing into."

But the sellsider said that being long the VIX in a note wrapper is still effective as a hedge.

"Unlike many other assets where you would expect a long-term increase in value, it's used as a put-buying strategy or it's like purchasing insurance," he said.

"That's why the VIX increases more in a down market than it decreases in a rally. You would expect that with insurance. You wouldn't expect to pay more in premium than what you can get in benefits."

Traders only

Because of the complexity of the volatility curve and the negative correlation between volatility and stocks, investing in VIX ETNs should be left to traders only or institutional players, sources said.

For the most part, that is the case.

"People who buy those VIX ETNs are mostly sophisticated market participants. We see very sophisticated high-net-worth asset managers and hedge funds. They have to have the mandate to buy these kinds of investments," said the sellsider.

Holding those instruments long term can also be a recipe for losses, sources said. Lloyd said that it is especially true for the short and leveraged versions of those notes.

"The performance characteristics of daily resetting leveraged and inverse products make them inappropriate for longer holding periods," he said.

At the present, the VIX futures are trading at a premium, said the market participant.

"Right now, the VIX is at a low. The lower the VIX is, the more expensive it is to buy the futures. So you have a high percentage in the VIX premium. The carry is very high. To give you an idea, the first month is at $15.55 and the second month at $20.00. There's a 22% premium in the VIX futures," he said.

As a result of this gap between the spot VIX and the futures, investors betting on a rise of the VIX need to have a high degree of conviction, he said.

So far, not much has been done from index providers to counter the negative roll seen with VIX futures contracts, sources said.

"I'm not sure if you have indexes on the VIX that address the contango issue," said the structurer. "Even some of the commodities indexes trying to achieve roll optimization don't really eliminate contango entirely."

"Futures on the VIX are not the best of hedges, but it's the only one we have," an industry source said.

Lee Kramer, president at Capital Management Analytics, disagreed.

"With volatility, contango is very strong. The steep rolling curve over time erodes value to the investor. I'd rather buy an option for protection. It's a better way to hedge," he said.

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