Everyone was warned that higher stock market volatility was coming. With presidential outcome uncertainty, expanding coronavirus cases and a lack of agreement on more economic stimulus among U.S. politicians, the high volatility bet seemed like a slam dunk. But that hasn’t been the case.
The CBOE S&P 500 Volatility Index, also known as the “VIX,” has declined 1.4% over the past month. Meanwhile, popular exchange-traded products tied to the VIX index—the iPath S&P 500 VIX Short-Term Futures ETN (VXX) and the ProShares VIX Short-Term Futures ETF (VIXY)—have both sunk about 12%.
Looking at it from a broader angle, the steady decline in stock market volatility has been a six-month trend that was briefly interrupted with a late-October pop and a November crash. Over this time, VIX linked ETPs have been crushed—falling almost 44% in value.
Should financial advisors and portfolio managers still bracing for higher volatility abandon ship on these VIX-related products?
VXX has $1.2 billion in assets under management and uses an exchange-traded note structure, which carries counterparty risk of the issuer, Barclays Bank. Despite this added dimension of credit risk, VXX enjoys healthy interest. In fact, at times the trading volume over a period of just one or two days is so robust that it often exceeds the note’s total assets under management. VIXY, which competes with VXX, eliminates credit risk with its ETF structure but has a smaller asset base of nearly $326 million.
Since there’s no way to invest directly in the VIX index itself, VIX-related ETPs use VIX futures contracts to obtain their index exposure. This puts VIX ETPs at the mercy of the VIX futures curve, which tends to curve upward and trigger something known as “contango.” This leads to decay in the underlying positions of VIX ETPs, leaving them less money to roll into upcoming futures contracts when the current ones they own expire. As this process repeats itself, it’s not uncommon to see huge double-digit long-term losses for VIX ETPs.
Are VIX ETPs the wrong way to bank on higher volatility? Not necessarily.
VIX ETPs can be useful risk management tools. For example, VXX and VIXY soared just over 250% when the stock market’s crashed in March and broadly diversified funds took it on the chin. As fear and panic selling kicked in, VIX ETPs were defensive hedges.
But as long-term trades, VIX ETPs tend to perform poorly. VIXY, for instance, has declined 45.8% since it launched in early 2011. The performance problems are largely due to the previously mentioned contango issue. As such, VIX ETPs are best implemented as short-term trading vehicles rather than buy-and-hold investments.
Stock market volatility is like a sleeping giant that never goes away. And we know the giant will periodically awaken and shake everything in sight. But perfectly nailing the timing is nearly impossible, thereby making it tough to profit from VIX ETPs.
As an alternative to VIX ETPs, advisors can consider using inverse-performing equity ETFs like the Direxion Daily S&P 500 Bear 1x Shares (SPDN) that aim for daily opposite exposure to stocks. Keep in mind that inverse ETFs perform horribly when stocks are in an uptrend. As such, both VIX-related and inverse-performing equity ETPs should be used judiciously.
Ron DeLegge is founder and chief portfolio strategist at ETFguide, and is the author of “Habits Of The Investing Greats.”