Volatility-based investing has dramatically risen in popularity over the last decade as investors have become increasingly sophisticated, diversifying from a simple portfolio of stocks and bonds. In fact, there have been days when trading volume in CBOE VIX derivatives exceeds that of the SPDR S&P 500 ETF (SPY). But there are issues investors must consider, noted an August TABB Group report titled “Volatility ETPs: When Traders Cash in on Turbulence.” Investors who don’t recognize how to maximize the benefits and avoid the pitfalls might experience disappointment.
Volatility trading steadily rising
The use of volatility-based investment products has significantly increased over the last eight years. In 2007 there were 23 million VIX options contracts traded, and to finish 2015 there were 145 million traded with 158 million projected to change hands in 2016.
The total number of volatility-based exchange traded products is estimated at upwards of 25, with the five most active contracts trading an estimated $946 million in notional value in 2016.
The growth in these products mirrors concerns for stock market hedging in an era of quantitative stimulus being withdrawn in the US, negative interest rates throughout the world and ever present geo-political concerns.
“We have seen a growing adoption of sophisticated volatility-based investing strategies even among smaller portfolio managers and retail investors,” said Callie Bost, a derivatives analyst at TABB who authored the report.
But with this increased adoption comes the need to understand the specific pitfalls as well as the benefits of the investment product.
Understand the dramatically sloping time horizon price structure, roll cost and tax issues
One of the most significant issues investors face when understanding volatility products is that they do not always follow the underlying VIX index tic for tic.
A significant issue is the price differential between the front month of the VIX futures contract and the typically much higher back months, particularly the fourth and fifth month contracts.
“VIX futures in the back months can get elevated,” Bost noted, creating trading challenges in both futures and options for owning the derivatives contract because it is often a depreciating asset as they become closer to expiration. “Sometimes people who buy and hold a VIX ETP are surprised they lose so much money to (asset depreciation) and roll costs.”
Bost notes that the more successful trade has been short volatility, betting the VIX will move lower after the price spikes. She explains in the report:
The VIX futures curve is typically in contango, or in an upward-sloping curve as VIX futures become more expensive with future uncertainty priced in. Volatility ETPs holding VIX futures must continuously sell near-term futures as expiration looms and buy far-dated futures. Contango forces the issuer to sell short-term VIX futures at a low price and buy long-term VIX futures at a high price. This leads to a slow deterioration of the product’s share price, a factor influencing investors to avoid using the product to hedge their portfolios.
The opposite situation can benefit an investor buying into a long-volatility ETP. The VIX futures curve tends to flip into backwardation, or the structure when near-term VIX futures are priced higher than longer-term VIX futures, in periods of perceived market stress. In these situations, the product sells near-term VIX futures at a high price, then buys further out VIX futures at a lower price.
As a point of reference, Bost notes the 2nd month VIX futures contract closed above the 1st month VIX futures contract (contango) in 74% of trading sessions in the first half of 2016, down from about 88% of trading sessions from 2010 to 2015. A small minority of the time is the contract in backwardation.
Tax and counter-party issues in the ETF vs ETN
In addition to understanding the contract’s depreciating asset value and roll-cost variables, investors should understand the tax implications and differentials between common ETFs and exchange traded notes (ETNs).
Volatility ETFs are taxed as a holder of an open futures position, 60% long-term / 40% short-term capital gains regardless of if the investor has sold his position, the report noted. ETNs, by contrast, are unsecured debt obligations that track the price of an asset or index as their issuers increase and decrease share counts.
Numerous volatility ETNs track indexes based on VIX futures, and thus still experience theoretical roll costs, the report highlighted. ETN investors enjoy a tax treatment similar to stocks, as they are only required to pay taxes on long-term capital gains when they sell shares of the note. A significant issue with the ETN, however, is that investors must also consider the creditworthiness of the issuer.
There are also ETN price fluctuations that can occur due to the issuer. For instance, in March 2012, Credit Suisse temporarily halted new share creations within the VelocityShares Daily 2x VIX Short-Term ETN (TVIX). This altered the supply and demand formula, limiting share supply and increasing the ETN’s to significantly diverge from the underlying VIX futures. One month later, Credit Suisse re-opened the ETN to new creations, causing the note’s price to plunge.
“Understand the benefits and risks before investing,” Bost advised investors.