Barclays' iPath S&P 500 Dynamic VIX ETNs aim to reduce cost of rolling during contango market

By Emma Trincal

New York, Aug. 15 - Barclays Bank plc's soon to price 0% iPath S&P 500 Dynamic VIX exchange-traded notes linked to the S&P 500 Dynamic VIX Futures Total Return index are designed to capitalize on the moves of the CBOE Volatility index by providing a cost-efficient exposure to the implied volatility curve.

The underlying index seeks to provide investors with exposure to forward implied volatility by reflecting the outcomes of holding long and at times long and short positions in futures contracts on the VIX index, according to a 424B3 filing with the Securities and Exchange Commission.

The VIX is a measure the implied volatility of S&P 500 index options.

The S&P 500 Dynamic VIX Futures Total Return index aims to react positively to overall increases in market volatility by allocating dynamically between the S&P 500 VIX Short-Term Futures Index Excess Return and the S&P 500 VIX Mid-Term Futures Index Excess Return.

Anti-contango

The underlying index is designed to reduce the costly effect of a market in contango, said Berlinda Liu, director of index research and design at S&P Indices, a unit of Standard & Poor's. She said the idea is the same behind the creation in January of the S&P GSCI Dynamic Roll index in another asset class: commodities.

Both the short-term VIX index and the mid-term VIX index are made of future contracts, which must be replaced as they approach expiration, the prospectus explains.

This process, called "rolling," can be expensive when the volatility curve slopes upward because at expiration, the contract will be sold and replaced with the purchase of a similar one with a later expiration.

The market is in contango when the price of contracts are higher in the distant delivery months than in the nearer delivery months, resulting in an extra cost of rolling called roll cost. It's this extra cost that the S&P 500 Dynamic VIX Futures Total Return index seeks to control, said Liu, who noted that the market for volatility futures contracts tends to be in contango "nearly two-thirds of the time."

"The S&P Dynamic VIX index is an index that dynamically allocates between two underlying indices: the S&P 500 VIX Short-Term Futures and S&P 500 VIX Mid-Term Futures indices," Liu said.

"The goal of the S&P Dynamic VIX index is to lower the roll cost while providing exposure to future implied volatility. The former is achieved through a long position in the mid-term VIX futures index, while the latter is better achieved through a long position in the short-term VIX futures index that tracks the VIX spot more closely," Liu told Prospect News.

"The dynamic allocation model achieves those two goals by allocating either long only or long and short positions to the two indexes based on steepness of the volatility curve."

The opposite of contango is a market in backwardation. In such case, the implied volatility term structure slopes downward and the rolling cost is lower.

Term structure bets

A market participant said that the current volatility market is in backwardation but that new products such as this ETN will be useful to investors trying to arbitrage between the short and the long end of the volatility curve.

"Over the past two weeks, the term structure of volatility has moved into backwardation," this market participant said.

"That has led investors to take an interest in the shape of the term structure of volatility rather than merely the absolute levels of volatility.

"This note is attractive to the investor looking for returns between short-dated and mid-dated volatility by dynamically allocating between the two indexes."

Because the underlying index dynamically allocates to the short-term VIX index and the mid-term VIX index, it enables investors to get exposure to different parts of the curve, he said.

The short-term VIX index seeks to model the excess return from a daily rolling long position in the first- and second-month VIX index futures contracts, while the mid-term VIX index seeks to model a daily rolling long position in the fourth-, fifth-, sixth- and seventh-month VIX index futures contracts, according to the prospectus.

The new ETN adds to a suite of existing ETNs from Barclays that includes the iPath S&P 500 VIX Short-Term Futures Index Excess Return ETN, the S&P 500 VIX Mid-Term Futures Index Total Return ETN, a short version of the VIX short-term ETN and a leveraged version of the VIX mid-term ETN. The latter was automatically redeemed last month due to an automatic termination event triggered in a low-volatility market. It was replaced by a new issue, the iPath Long Enhanced S&P 500 VIX Mid-Term Futures ETNs (II).

Not for the little guy

For some financial advisers, volatility-based products offer advantages but are limited in their use.

Michael Kalscheur, financial adviser at Castle Wealth Advisors, said that complexity is one of the drawbacks.

"Most people don't know what the VIX is," he said. "So you have to explain it to them and then explain what the short-term VIX index is, what the mid-term VIX [is]. It's a very complicated conversation."

Another problem with new indexes, he noted, is that track records are often lacking.

"It's a good insurance policy for the worst of the worst. But I would be interested to see how it performed last week."

Kalscheur said that the decision to introduce a VIX-based product in a client's portfolio would depend on one's view about volatility and whether it can be considered as a stand-alone asset class.

"Personally, I wouldn't see volatility as an asset class. We do not treat it as such. We do not have allocation to it for any of our clients," he said.

"Any portfolio can benefit from an allocation to blue-chip stocks; any portfolio can benefit from an allocation to bonds, etc. But volatility is not for everyone.

"Could it add alpha? Could it add value to clients? Absolutely. I'm not saying it can't work or that you can't use volatility as a hedge or as a way to generate alpha. But you have to know what you're doing. You have to understand what the product will do, what it won't do. This is not for retail investors.

"For the right person with the right portfolio watched carefully, it's something that could add value. But unless you're a sophisticated investor who really understands it, I would stay clear."

The tenor of the notes has not been set.

The notes will have a face value of $50 each.

The net effect of the fee will be 0.95% per year.

The issuer plans to apply to list the notes on the NYSE Arca under the ticker symbol "XVZ."

Barclays Capital Inc. is the agent.

The Cusip number is 06741L609.

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