With stocks extending their bull run into 2013, even typically anxious investors are breathing a rare sigh of relief. Indeed, the CBOE Volatility Index (VIX)––which uses futures trading activity as a gauge of investor fear––is at its lowest level in six years. As defined by the Chicago Board of Trade, the VIX measures market expectations of near-term volatility conveyed by S&P 500 stock index option prices.
But are investors too complacent? Few people can spot major turns in the market, especially those triggered by unforeseen events known as “Black Swans” that can cause markets to tumble and volatility to surge. And even foreseen events can unsettle the markets, such as when the prospect of a looming government shutdown last summer pushed the VIX from around 16 on July 1 to 48 by August 8—a 200 percent jump in just six weeks. Some leveraged exchange-traded funds and exchange-traded notes that play off of the VIX rose by even greater amounts.
Think about these funds as protection for your portfolio. If your stock holdings quickly drop in value due to market-rattling events, then the VIX funds will likely rally in response. Of course, it’s unwise to make a major investment in these volatility-focused funds. Instead, they should account for no more than 5 percent or 10 percent of any portfolio.
Although many investors use the ETN as a hedge against a long-oriented portfolio, such insurance doesn’t come cheap: They typically carry expense loads of around 1%, and as the portfolio of futures contracts are rolled over every month, these funds can lose a bit of value in the transition through negative roll yield, or contango.
“The heavy costs for this insurance lead us to suggest only small stakes be picked up when volatility trades in the lower half of the historical range,” Morningstar analyst Timothy Strauts wrote in a report. He said it’s wise to buy the VIX when it’s below 20 (where it is today) and sell any VIX-related investments when the index moves above 30.
Three Paths: Direct, Leveraged And Inverse
Perhaps the most direct way to invest in volatility is though the iPath S&P 500 VIX Short-Term Futures ETN (VXX). This note owns a series of short-term futures contracts that need to be rolled over into the next month’s contracts at fixed intervals. “It is especially useful for institutional investors that want to put on a short-term position, but it’s not quite as suitable as a buy-and-hold vehicle,” says Francesco Mazzini, head of ETN product development for Barclays.
This fund was down 26 percent year-to-date as of February 7, and has suffered annualized losses of more than 65 percent since its launch four years ago.
Perhaps a safer way for financial advisors to employ the VIX in their client portfolios is with the Barclays S&P 500 Dynamic VEQTOR ETN (VQT), which has exposure to both the VIX and the S&P 500. Strauts wrote that this ETN represents “a portfolio with below-average risk that can actually rise in a down stock market.” The fund re-balances daily to adjust for changes in both the VIX and the S&P 500, and increases its weighting on the VIX when volatility is rising.
Funds focused purely on the VIX tend to bleed out value over time, losing a few pennies each month every time the contracts roll over. The VQT, which has a big position in the VIX only when volatility is rising, doesn't bleed very much. So you could own it for six to nine months and not see much in the way of contract rollover losses.
This year, the VQT was up nearly 2.5 percent through yesterday, and has annualized gains of 11.45 percent since its August 2010 inception.
Some investors see VIX ETFs and ETNs as being more than just a defensive hedge––they also see it as a quick winning trade. When the market invariably experiences a bit of periodic indigestion and drops in value, the VIX can move up quickly., And when that happens, leveraged ETNs are a better way to go because they can double or even triple in price in a short time frame.
One option here is the ProShares Ultra VIX Short-Term Futures ETF (UVXY), which moves at a much greater rate than the VIX. To be sure, it’s a very risky method of betting on volatility because shares have fallen sharply as volatility has waned (the fund has walloped investors with a nearly 48 percent loss so far this year), and it sports a hefty 1.41 percent expense ratio. Obviously, this fund should constitute only a very small portion of any portfolio and is meant for quick trading.
But when volatility increases, this fund is likely to quickly double or triple (or more) in value in a very short time frame. For example, as concerns grew in mid-December that the U.S. government might shut down in the face of a budget impasse, this ETF rose more than 50 percent in just seven trading sessions.