Trading Volatility Is Difficult

Which of these two would you rather hold?  The following graph shows the normalized year-to-date performance of two very similar items.  One is up over 29% in that time frame, which is a robust rise, but it pales in comparison to its counterpart, which is up over 72%.  Let’s take a look:

Year-to-date Normalized Chart of Two Items to Be Revealed Later

Source: Bloomberg

Obviously one would rather hold the item displayed by the green line.  Who wouldn’t want to hold something with more than double the return of the other?

The problem is that the green line shows the performance of the CBOE Volatility Index (VIX), which is not directly investable.  There are VIX futures and options, but while they are actively traded products, none of them enable a trader to actually hold the index.  VIX is not like the S&P 500 Index (SPX) upon which it is based.  One can buy the 500 stocks that comprise SPX in the proper ratios.  Realistically, doing so is the exclusive province of institutional investors, but there is no shortage of index funds and ETFs that allow individual investors to own a small pro-rata slice of that portfolio.   VIX is instead “a calculation designed to produce a measure of constant, 30-day expected volatility of the U.S. stock market, derived from real-time, mid-quote prices of S&P 500® Index (SPX℠) call and put options.”  In theory one could buy all the options with non-zero bids that make up the continually changing VIX calculation, but doing so is essentially infeasible.  That is why investors use proxies like futures, options, and ETFs to gain exposure.

A popular proxy is VIXY, the Pro-Shares VIX Short-Term Futures ETF, which is represented by the blue/white candles in the graph above.  My original gut instinct was to criticize the ETF itself for the underperformance.  We have previously discussed the systematic underperformance of an ETF that holds derivatives because those derivatives expire.  Futures and options must be rolled prior to expiration, which has a slippage cost.  More importantly, options decay, and a futures market that is in contango tends to see futures with longer expirations decline in value relative to the front contract.  Yet in the case of VIX, if we want exposure to the underlying index we really don’t have a choice about owning derivatives.  The following graph shows that VIXY have tracked the futures rather well, actually:

Year-to-date Normalized Chart of VIX (green), VIXY (blue/white), January (purple) and February (red) VIX futures

Source: Bloomberg

The inversion of the VIX curve has likely helped VIXY, because it allows them to replace near-month and near-week futures with longer-term counterparts that are trading at lower prices.  That offsets the roll costs outlined in the article linked above.

My aversion to derivative-linked ETFs is well-noted.  I urge everyone who considers owning one to read the prospectus, particularly those that offer 2X, 3X or inverse performance.  These instruments acknowledge that while they attempt to match the daily performance of their benchmark, they tend to systematically underperform.  Here is an excerpt of the Proshares Trust II filing, which includes VIXY:

“THE RETURN OF A GEARED FUND FOR A PERIOD LONGER THAN A SINGLE DAY IS THE RESULT OF ITS RETURN FOR EACH DAY COMPOUNDED OVER THE PERIOD AND USUALLY WILL DIFFER IN AMOUNT AND POSSIBLY EVEN DIRECTION FROM THE GEARED FUND’S STATED MULTIPLE TIMES THE RETURN OF THE BENCHMARK FOR THE SAME PERIOD. THESE DIFFERENCES CAN BE SIGNIFICANT.”

It is incumbent upon anyone investing in an ETF that uses derivatives to understand this concept.  But if one wants to use a volatility-tracking ETF, they have little choice but to utilize this type of instrument.