VIX ETPs Demystified – December 2011

Just like most humans (monozygotic twins excluded) are not created equals, most VIX futures based exchange-traded products (ETPs) are not equal (At the time of writing this post, there were 43 primary listed ETPs). While there are a number of distinctions and I will attempt to highlight the key areas, but first the few common themes are:

1) They all use swaps to some degree
2) They are all linked to VIX futures (and maybe other assets, but not VIX spot or the VIX Options)

This is not to say that these are the only commonalities, but these are among the most important ones. The key areas of differences for these ETPs are:

1) Structure – These can be structured as exchange-traded notes (ETNs) or exchange-traded funds (ETF), depending on the issuer. Depending on the structure, there may be certain provisions that would be imposed on the investor. e.g. ETNs tend to have an automatic acceleration provision that initiates redemptions if certain trigger thresholds are breached.

2) Exposure – The exposure can vary by maturity i.e. 30-day, 60-day, 5-month, etc.; overcome certain investment impediments such as to reduce roll cost like Term Structure or Dynamic VIX Futures; or for use as an asset allocation tool.

3) Issuer/Sponsor – A number of product issuers globally are offering products – Barclays Capital (through iPath or Barclays ETN+), VelocityShares, ProShares, UBS (Through E-TRACS platform), Source (in Europe), Kokusai Asset Management (in Japan), Citigroup and BetaPro (in Canada)

4) Fees – The fees for different products offered by different sponsors varies. An investor should look through the prospectus to identify “all-in” cost prior to deciding which product to use.

Click here to view the file which lists the 43 products and outlines their structure, AUM, and other high-level characteristics of these products.

An Introduction to VIX

Volatility has emerged as an important asset class in its own right over the past decade. Book-ended by two equity bear markets, the past decade (2000 – 2010) saw heightened financial stresses and large losses in investment portfolios. The investment community’s need for tools and instruments to protect downside risks had never been more acutely felt. As the saying goes, necessity is the mother of invention, and this sentiment holds true in the realm of financial engineering.

Since its introduction in 1993, the VIX, the Chicago Board of Options Exchange’s (CBOE’s) volatility index, has become widely considered the “fear gauge” of the market. The VIX measures the implied volatility of S&P 500 index options, representing the market expectation of stock market volatility for the next 30 days. Market participants quickly discovered the value of the VIX index in hedging portfolio risks, since the VIX was found to be negatively correlated with the returns of the equity market, as measured by the S&P 500. Furthermore, the level of correlation increases as the equity market sells off. Due to this asymmetry in correlation, the VIX is an ideal hedge for a long-only equity portfolio.

Recognizing the importance of the VIX index, a host of new products based on the VIX were introduced in the past decade. In 2004, the CBOE Futures Exchange (CFE) introduced futures trading on the VIX, and the CBOE listed an options contract on the VIX in 2006. In 2009, S&P Indices introduced the S&P 500 VIX Futures Index Series, which is now the basis for a growing list of more than two dozen ETNs and ETFs, linked to more than US$ 2 billion in assets (Liu and Dash, 2011). These instruments have driven the VIX’s evolution from a market indicator to a hedging vehicle.

Diversification Properties of VIX Futures Indices

As in the VIX index spot, the S&P 500 VIX Futures Index Series and the S&P 500 tend to move in opposite directions or.  As shown in Exhibit 1, while the correlation between the spot VIX and the futures index series is not perfect, it is a healthy 89% for the short-term index and 80% for the mid-term index.  More importantly, the correlations of the short-term index and mid-term index to the S&P 500 are -80% and -78%, respectively, closely approximating the -77% correlation of spot VIX with the S&P 500. 

Exhibit 1: Correlation of Indices with VIX and the S&P 500 (Dec. 2005 – Dec. 2011)

VSTOXX Short Term Futures Index and VSTOXX Mid Term Futures Index are calculated since late 2010. Despite their short history, they demonstrate high correlation with VSTOXX spot and high negative correlation with EURO STOXX 50. VSTOXX Short Term Futures Index is 85% correlated with VSTOXX and -85% correlated with EURO STOXX 50 since September 2010. VSTOXX Mid Term Futures Index is 81% correlated with VSTOXX and -86% correlated with EURO STOXX 50 since November 2010.

Exhibit 2 below shows that daily falls in the S&P 500 are highly likely to be accompanied by rises in the VIX spot and the two VIX futures indices.

Exhibit 2: Probability of VIX Rises Given Particular S&P 500 Falls (Dec. 2005 – Dec. 2011)

Particularly during periods of market stress, the rise in the two VIX futures indices is substantial, as shown in Exhibit 3. Exhibit 4 shows the diversity property holds in Europe.

Exhibit 3: 20 Biggest Daily S&P 500 Falls from Dec. 2005 to Dec. 2011

Exhibit 4: 10 Biggest Daily EURO STOXX 50 Falls in 2011

Volatility Benchmarks in Europe

In Europe, regional volatility indices have been developed and published to measure the implied volatility in local markets. VSTOXX, VDAX-NEW, VFTSE follow the CBOE VIX methodology and have become the investor fear gauge in the Europe, German and UK markets. Exhibit 1 shows that these indices are highly correlated. Since Jan. 2000, VSTOXX have been 91% correlated with VDAX-NEW and 80% correlated with VFTSE. This reflects the high correlation among the European local equity markets. In the same period, EURO STOXX 50 is 93% correlated with DAX and 89% correlated with FTSE 100. These three European regional volatility indices are moderately (51 – 52%) correlated to CBOE VIX, which reflects the moderate correlation (53% – 61%) between the European and US equity markets.

Exhibit 1: Volatility Benchmark Indices in Europe and US (Jan. 2000 – Dec. 2011)

Exhibit 2 shows that the negative correlation between the equity market and its corresponding volatility benchmark is maintained in Europe. Since the beginning of 2000, VSTOXX is -75% correlated to EURO STOXX 50. This is in line with the correlation (-76%) between VIX and S$P 500. In the same period, the correlation between VDAX and DAX and the correlation between VFTSE and FTSE 100 are both -70%. 

Exhibit 2: VSTOXX and EURO STOXX 50 Performance History (Jan. 2000 – Dec. 2011)

First Day of the Year Typically More Volatile

The 1.55% gain opening day marked the 29th time that the year’s opening day changed at least a 1% (17 up at least 1%, 20.2%, and 12 down at least 1%, 14.3%) in the last 84 years (since 1929, including today), a 34.5% rate.  The high 34.5% rate compares to the 23.9% historical rate of 1% moves (12.1% up and 11.8% down)

A New Application for VIX®: Hedging Bond Portfolios

Equity volatility is frequently used to hedge equity portfolios, but some bond portfolios may also stand to benefit from an allocation to equity volatility.   Read the latest research paper from S&P Indices to learn why corporate and emerging market bonds may enjoy hedging benefits.  Read more…

Contango and Roll Cost


Although VIX spot is generally mean reverting, the S&P 500 VIX Futures indices are return generating time series that trend down for the majority of their history. This downward trend is particularly obvious in the Short Term index.

This is because the price received from the sale of the shorter term contract is generally less than that paid for the longer term, as expected VIX is generally greater than current VIX. Additionally the spread between the shorter term futures and the longer term futures is generally bigger on the front month contracts.

This feature is not unique to VIX futures. Commodity markets often experience these conditions, a phenomenon known as contango.

Roll cost is inevitable when the market is in contango since one futures contract has to be rolled into a longer term one prior to its expiration. The continuous daily roll of the two futures indices only spread the cost throughout the month. It does not necessarily change the magnitude of the cost.

In the S&P 500 VIX Short-Term Futures Index, contango occurred 77% of the days since inception.  On average, 0.18% of the portfolio value was lost daily by rolling from the first month futures to the second month futures.

In the S&P 500 VIX Mid-Term Futures Index, contango occurred 64% of the days since inception.  On average, 0.07% of the portfolio value was lost daily by rolling from the fourth month futures to the seventh month futures.

ETPs that track these two indices are trading vehicles, not buy-and-hold products.

VIX futures indices only track a fraction of VIX spot return

It has been widely observed that the S&P 500 VIX Short Term and Mid Term Futures indices track only a fraction of the VIX spot return. For example, on 8/8/2011, in response to the US Teasuries downgrade, the S&P 500 fell 6.88%, the biggest drop in 2011 (fingers crossed!). On the same day. VIX spot jumped 40.55%, but the Short Term index only jumped 17.44% and the Mid Term index jumped 6.96%.

Overall, the Short Term index has a beta of 43% with the VIX spot, and the Mid Term index has a much lower beta of 21%. This is because the futures market is usually less sensitive than the spot to equity market movement. Furthermore this sensitivity declines with longer dated contracts.

Note that we see NO loss in correlation or diversification properties in the futures market, however. The correlation of the Short Term and Mid Term index to the S&P 500 are -80% and -78%, respectively, closely approximating the -76% corrleation of the spot VIX with the S&P 500.

Similar correlation means similar diversification;

Lower beta means higher hedge ratio.


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