The VIX – Fruition of an Asset Class… Almost

Managing volatility exposure is a natural step forward in the evolution of portfolio management. During recent periods of high volatility in 2008-2009 – and to some extent 2010 – we’ve seen the VIX be an effective hedge against market downturns.

An S&P white paper examined the period of 2007-2009 and found a negative correlation that reached up to 74% (highest during down moves) between the spot VIX and the S&P 500. This is particularly important since recently, many asset classes continue to show increased correlation. There is also fear of a multi-asset ‘splash crash,’ as algorithmic trading has spread beyond equities to currencies and fixed income, making a non-correlated hedge all the more crucial.

The VIX tends to spike during large downturns in the market, making a long VIX position a useful hedge for an equity portfolio. Even in periods of market upturns, actual price volatility can be a drag on portfolios in reducing compounding returns. A position on the VIX with a long equities strategy could yield diversification benefits. The trick would be to be to capture volatility spikes that tend to accompany market sell-offs and minimize carry costs, or even short volatility, during periods of calm or market growth.

While OTC variance swaps is the usual go-to choice to take a position on volatility, new VIX exchange-traded products (ETPs) are an intriguing alternative. Barclays, UBS, Credit Suisse and Citigroup have all recently issued VIX futures-based exchange traded notes (ETNs) that take a big step in reducing the complexity of adding VIX exposure to a portfolio.

The VXX, from Barclays for example, one of the first of many VIX ETNs introduced last year, tracks the S&P 500 VIX Short-Term Futures Index for exposure to a long position in the first and second month VIX futures contracts, rolled continually to achieve a constant maturity of 30 days. It is already very popular, with a 20-day ADV of 4.3 million shares. VXX also has an inverse counterpart, the XXV, that has been trading with a 20-day ADV of 32,000 shares. It’s not quite as popular since VIX short strategies using ETPs tend to fall within a niche realm of a short-term day traders. The liquidity of the VXX makes it a viable option for investors taking short-term positions on the VIX as a hedge on their portfolio. A slew of VIX ETNs have been released (VIIX, CVOL, VXZ to just name a few), many of which are structured similarly.

As ETNs, they have the benefit of no post-fee tracking error and the only tax is capital gains incurred when bought or sold upon maturity. The typical fee for these VIX ETNs is around 0.89 percent. A quick look at the average bid/ask spread for the VXX ETN on ARCA shows it at two to three basis points. As ETPs they also have the advantage of efficient price discovery and greater trading transparency.

However, there are some critical issues that investors need to keep in mind when using VIX ETNs to put on a volatility hedge or add diversification to their portfolio returns. The short end of the volatility futures curve is usually in severe tango (sloping upwards in price with maturity), so continual rollover between contracts has a substantially negative impact on yield. The near-term VIX futures are also priced at a high premium to the spot VIX, reflecting both its risk premium and its popularity as a hedge. This makes the timing of the ETN trade especially important.

However, Wall Street is always quick to adapt and new ETNs attempt to address these issues using combined positions or even leverage to enhance returns. For example, take the innovative Long-Short XVIX from UBS. XVIX’s underlying index is essentially 50 percent short S&P 500 VIX Short-Term Futures and 100 percent long S&P 500 VIX Medium-Term Futures (which targets a constant weighted average futures maturity of five months). The short component allows investors to profit from both the price premium of short-term VIX futures and the rollover when its term structure is in contango. The long component allows investors to maintain a rolling long position in VIX futures farther out the curve and capture some of the upside when volatility spikes. While only introduced last November, the XVIX has average daily volume of 37,000 shares. It’s a step in the right direction in simplifying VIX trading.

For pension funds and other large institutional investors that already use swaps, OTC solutions continue to be the optimal method to manage volatility. The customized OTC variance swap in particular gives direct exposure to the volatility of the underlying security. It offers the convenience of a specified timeframe and pure exposure to the realized variance (variance is the square of volatility). Compared to VIX futures, these OTC swaps avoid the burden of rolling and the added ‘risk premium’ that come embedded option prices.

All-in-all, the ability to customize a volatility position with minimal carry cost and lessened uncertainty make the OTC variance swap a superior solution. With Dodd-Frank swap reform in the fast approaching, we’ll see whether that remains the case in the future. Nevertheless, as VIX ETPs continue to evolve I imagine they will closely mirror OTC solutions to be effective alternatives for smaller investors.

Volatility is the next big thing for portfolio management. VIX is in the spotlight.