If you surveyed investors, the majority would probably tell you they want nothing to do with stock market volatility. That’s because all of the ups and downs associated with investing in stocks can be emotionally stressful and even frightening as people watch the value of their investments bouncing around.
Adding to this truth is the launch of ETFs including the iShares MSCI USA Minimum Volatility ETF (USMV), PowerShares S&P 500 Low Volatility ETF (SPLV), Direxion S&P 500 RC Volatility Response Shares (VSPY) and others like them that aim to reduce the influence of market gyrations. This fairly new breed of volatility-killing ETFs has been a hit with investors and already amassed almost $12 billion in a span of just two years.
In reality, the financial services industry has conditioned the investing public to view stock market volatility as an enemy rather than an opportunity. Does it ever make sense to own volatility instead of avoiding it? How can advisors use market volatility as a profit opportunity?
The CBOE Volatility Index, or VIX, was launched in 1993 and is the go-to gauge for measuring stock market volatility of the S&P 500 by using index options prices.
The VIX is quoted in percentage points, and converts roughly to the expected movement in the S&P 500 index over the next 30-day period, which is then annualized. For instance, a VIX of 13 means the market expects the S&P 500 to swing up or down 13% on an annualized basis over the next 30 trading days.
Although it’s impossible to invest directly in the VIX, advisors can obtain exposure to it by using VIX futures contracts, call/put options and VIX-linked ETPs. Let’s examine the latter.
If you’ve ever traded in volatility, you’ve personally experienced or are at least aware of the performance discrepancies between the CBOE S&P 500 Volatility Index and VIX ETPs like the iPath S&P 500 VIX ST ETN (VXX).
The latest prospectus (dated July 31, 2013) for the ProShares VIX Short-Term Futures ETF and the ProShares Ultra VIX Short-Term Futures ETF (UVXY) alludes to some of the problems with getting VIX exposure via ETPs by saying: “High volatility may have an adverse impact on the VIX Funds beyond the impact of any performance-based losses of the underlying indexes, especially the geared (or leveraged) fund may perform differently than the Short-Term Index.”
Further: “The VIX Funds are benchmarked to the Short-Term Index. They are not benchmarked to the VIX or actual realized volatility of the S&P 500. The level of the Short-Term Index is based on the value of the relevant futures contracts (‘VIX futures contracts’) based on the Chicago Board Options Exchange Inc. (‘CBOE’).”
Here’s one expert’s view: “Traders need to remember that VIXY gives you exposure to the front two-month VIX futures contracts. There can be a disconnect in the performance between VIX futures and the VIX index that results in different performance out of VIXY and VIX,” said Russell Rhoads, CFA, an instructor with the Options Institute at the Chicago Board Options Exchange and author of Option Spread Trading: A Comprehensive Guide to Strategies and Tactics (2011, Wiley).
Put another way, VIX ETPs don’t necessarily track the VIX index itself; buyer beware.
A Case Study
Quiz question: What was the best performing asset class for the tumultuous one-month period leading up to the Oct.16 agreement to temporarily suspend the U.S. government’s debt limit? If you guessed stocks, bonds or gold—you’re wrong. But if you guessed volatility, you hit the bull’s-eye.
In the one-month period from Sep.15 to Oct. 15, 2013 the VIX index soared 29.4% and easily outperformed all major asset classes including stocks and bonds. Even gold, which has been widely sold as the ultimate hedge, lost 2.15% and ended up being a poor choice.
How did VIX ETPs perform?
VIXY, which like VXX tries to capture the short-term performance of the VIX, increased by just 8.38% compared to the VIX’s 29.4% jump. Meanwhile, call options on the VIX itself performed more in line with the VIX’s short-term movements.
The ETF Advisor Pro Newsletter (published on Sept. 20 by this author at ETFguide.com) alerted readers that owning volatility by using VIX call options, not VIX ETPs, was the best way to play the October surge in market uncertainty. The VIX call options trade recommended in the October newsletter gained 30.5%. Also, they were bought and sold as a short-term strategic trade versus a long-term buy-and-hold play.
Although VIX call and put options generally do well at tracking the VIX, they eventually expire and are best used as short-term trading instruments because of time decay. The same is true of VIX ETPs, which use futures contracts to obtain their VIX exposure.
“The problem with the VIX ETPs is that people buy and hold them not understanding that there’s deterioration in the underlying. VIX ETPs are a derivative of a derivative and structure matters,” said Dan Weiskopf, a portfolio manager for the Access ETF Solutions group of strategies with IPI Wealth Management.
With roughly $3 billion scattered across 20 different U.S. listed volatility ETPs, it’s safe to say there’s a lot of misguided money chasing volatility.
Like insurance, the best time to buy the VIX is when the sky is sunny and stock market volatility is low. And for most of 2013, the VIX has traded in an extremely affordable range of the mid-teens. Even though it’s been an insurance buyers’ market, it won’t always be that way.
“The longer term mean of the VIX is around 20,” said Mark Sebastian, Swan Wealth Advisors’ director of trading and investments. That means from a hedging perspective, buying volatility at today’s levels has been historically inexpensive.
Typically, the VIX has moved in the opposite direction of the S&P 500 roughly 80% of the time, making it an excellent way to protect against sliding stock prices. Remember: Buy the insurance when it’s cheap.
Lastly, if you’re trading the VIX for capital gains, make sure you’re using the right vehicles and make sure you’re investing with a short-term time horizon. It’s OK to own volatility, but it’s not the kind of asset class you buy and forget.