Understanding VIX ETFs by Dave Nadig, Director of Exchange Traded Funds – FactSet

With volatility near multi-year lows, my email box has had more than the usual number of requests to discuss the pros and cons of trying to “play” volatility using one of the dozen or so volatility-based ETFs on the market. On the one hand, I get the appeal; if something seems artificially low, it’s logical to want to invest in it before it goes up. On the other hand, volatility exchange traded products are some of the most complex ETPs trading.

The straw that broke the camel’s back was the recent spate of articles with headlines touting the enormous short position hedge funds have in volatility futures, as some sort of evidence that volatility could somehow go even lower. I’ll come back to why that’s wooly thinking, but let’s start with what the heck an investment in a Volatility ETF even is.

The VIX

At the root of most volatility ETFs is the CBOE Volatility Index (VIX).  It’s often called the “fear index” and mislabeled “market volatility” on TV. What it actually is, however, is much more complex (and worth reading, if you’re a deep nerd). The VIX is calculated using the implied volatility of a basket of options on the S&P 500, both those about to expire, and those expiring next month. The idea is to come up with a number that represents the level of volatility the options market is expecting in the S&P 500 over the next 30 days. It’s essentially reverse engineering the math that options traders are using when they decide just how much to pay for a put or a call.

Related: ETFs: Who’s Buying What?

There are a few very important things to note here. The first is that there’s no direct mathematical relationship between the actual volatility of the S&P 500 and the VIX. The second is that it’s a forward-looking guess. The actual volatility of the market can be theoretically very low, while options traders are panicking about next month, and send VIX skyrocketing. Similarly, the market could go bananas and options traders could be sanguine about next month, and have VIX much less affected than you might expect.

In practice, what generally happens is that VIX rises substantially in response to downside surprises in the market. That’s the reason many investors have (for better or worse) seen an “investment” in VIX as a kind of hedge against market risk. It definitely has worked that way in short term crises, like last August:

VIX ETFs

VIX Futures

Practically speaking, you can’t just “buy” the VIX, unfortunately. Instead, the CBOE has futures contracts on the value of VIX that are widely traded. Like any futures contract, the VIX futures are simply a bet on where a particular number is going to land on a particular day in the future. So while an oil future bought today might say “I want the right to buy oil for $40 in a month,” and thus be worth $2 when oil is trading at $42 on settlement day, a VIX futures contract is pegged against a certain value for VIX.

To put it another way, a futures contract for a month out is betting on what options traders, a month from now, will be predicting the volatility of the S&P 500 will be for the thirty days after that. In other words, not only are you not tracking actual market volatility, you’re buying a derivative (the futures contract) on a derivative (the implied volatility of the options).

VIX Futures Indexes and ETFs

Every ETF tracks some form of an index of VIX futures, the most popular ETFs, like the iPath S&P 500 VIX Short Term Futures ETN, track the S&P 500 VIX Short Term Futures Index. That index, rather than simply buying the near term contract and rolling it as it expires, actually rolls every day in order to make it’s notional exposure always 30 days out. So on the day that one month’s contract expires, it will be 100% in the nearest month. The next day, it notionally sells a small portion in order to buy the second month contract, repeating that process every trading day. The idea is to provide some level of “smoothness” in the daily roll.

Why does that matter? Because pretty much since the dawn of the modern VIX futures market, near-term VIX futures have been in contango.  Here’s what the curve looks like right now:

VIX ETFs

As I write this, the VIX futures settling September 21 are $14.70. The October 19 contracts are at $16.92. Spot VIX is at 13.02. That means if VIX remains at current levels, the contango from Spot to front month is 13%, and 15% between September and October. Annualized that’s a 330% or 440% annualized headwind. This crippling contango is persistent in VIX futures for a pretty simple reason—the future is always unknown, and thus an estimation of potential outcomes has a wider variance than the driver of immediate volatility in the market, which is information.

The side effect of this contango is that any long term investment in a VIX futures based products ends up having enormous difficulties. Here, for example, is the actual spot VIX vs the biggest short-term ETP, VXX, and the inverse version, the VelocityShares Daily Inverse VIX Short-Term ETN, XIV:

VIX ETFs

Over the last year, VIX is down almost 50%, but the ETF tracking it is down almost 65%. You might think that the inverse version would be up 65%, but in fact it’s “only” up 40% in the last year. The reason for this is the way daily rebalancing affects the performance of all leveraged and inverse products; if the path of the thing being tracked (in this case, VIX) is itself volatile, the daily rebalance adds an additional drag on performance (in a smooth trending market, this actually works in your favor, delivering better than expected performance, but VIX is rarely in a smooth trending market).

Nuts and Bolts

All of this brings us to the sticky wicket in these products. Let’s do some quick math on how important these ETFs are in the market for volatility, back of the envelope style. Here are all the VIX ETFs listed in the US, with their assets in mid August:

VIX ETFs

VIX ETFs

Those tracking the first and second month futures (the short term products), had $2.3 billion in notional exposure. Some of these products are Exchange Traded Notes, like XIV. For XIV to actually get its exposure, a bank (in this case, Credit Suisse) actually issues debt that will promise the pattern of returns of a short position in the VIX futures index. To offset that risk, the ETN issuer goes out into the market and buys offsetting exposure in the futures market—in this case, they’ll sell a bunch of futures to match the index. If the ETN goes up in value, so does their short position, so it all balances out.

Some of these products, like VXX, are in fact regular old mutual funds under

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