New VIX ETF launching

There's a potentially important new ETF launching next Tuesday, May 19th, which allows investors to invest in the well-known CBOE Volatility Index.

Will it do a better job of tracking the VIX than other ETF and ETN products? The answer is likely yes, but there are some wrinkles.

The CBOE Volatility Index measures the intensity of put and call buying for the S&P 500 for a 30-day period and is often referred to as the "fear index."

The new Volatility ETF is attracting more attention than usual because the brains behind it is Robert Whaley, the man who invented the VIX.

His company, AccuShares, will float two different VIX ETFs: 1) the Spot VIX Up Class (VXUP), which seeks to track the VIX over a one-month period, and 2) the AccuShares Spot VIX Down Class (VXDN), which seeks to track the inverse performance of the VIX over a one-month period.

Why an inverse ETF? It has to do with how the ETF is structured.

Other ETFs exist to track spot indices—including commodites like oil—but they buy future contracts in their respective sectors. When the contracts expire, the next contract has to be bought, which greatly increases the cost of investing, since most future contracts are in contango, that is, the cost of the contracts further out are more expensive.

So you are usually buying high and selling low.

That creates tracking errors from the index. In other words, most investors find the investment they bought does not track the spot index they want to follow.

AccuShares is trying a different approach with this VIX product, and with other spot indices they will be launching in the near future. They hold cash and cash equivalents. Each ETF has an "up" asset class and a "down" asset class. Assets are swapped back and forth, depending on the increase or decrease in the spot price.

On the 15th of every month, everything is recalibrated. So you are essentially making a bet on where the VIX might be in the middle of the month.

With that said, there are a couple important details:

1) This is not free. There is a management fee of about 90 basis points a year.

2) There is a monthly distribution. Because this is cash, any accrued interest is paid out to shareholders (they park the cash in Treasurys). While it does create tax issues, it is treated as ordinary dividend income and will be reported on a 1099 form.

3) if you own the Long VIX there is a "tail risk insurance premium" that is paid the Short VIX of 15 basis points a day.

Why? Whaley pointed out to me that the VIX is not like a stock. That's because everyone knows that at some point the VIX will spike up—in some cases dramatically—in response to some event. It will also come back down again.

This has a very simple implication: at some point, you are going to make money if you buy the VIX, because we all know it is going to go up at some time. You just have to hold it, and voila! At some point it will go up, and you will make money.

What this means is that shorts are disadvantaged by definition. Who is going to sell you this product knowing that you are guaranteed to make money at some point, and they are guaranteed to lose money?

No one. So longs have to compensate the shorts for the risk of being short.

Why 15 basis points? Whaley tells me that is the point at which his team felt that market participants were willing to make a market in the products.

So, does it track the VIX? Let's take a look at an example.

On a daily basis, it seems to be pretty close. For example, from May 4th to May 5th, the VIX moved 11.4 percent, from 12.85 to 14.31.

If you deduct the 15 basis point fee, you have a gain of 11.25 percent, minus a management fee of roughly 0.0025 percent, the one-day cost of that annual 90 basis point fee, which gets you to 11.2475 percent.

VIX up 11.4 percent, you get 11.2475 percent. Not bad. Pretty close.

But that is for one day. The tracking error gets larger if you hold it for longer periods.

Suppose you invest $1,000 in the Up ETF (VXUP) on the 15th of the month and one month later the VIX is up 10 percent, so the value of the fund is $1,100.

Here's what you will have: 1) the $100 from a 10% gain, 2) whatever interest rate you get from short-term Treasuries (a few pennies), because the fund parks the cash here, 3) less the daily 15 basis point fee, which over thirty days would amount to $45, 4) minus the management fee of one-twelfth of 90 basis points, which is roughly $0.77, let's call it $1.

So you'd have a gain of roughly $100-$45-$1 = $54 or a roughly 5.4 percent gain.

That is not the same as a 10 percent gain, BUT you would get something that is directionally correct.

Bottom line: you'd have an index that tracks the VIX, but how closely depends on how long you hold it. You are paying a significant fee for the option-like privilege.

That sounds like an awful lot of fees, but when you compare how much is lost by the cost of carrying futures in the alternative products that use VIX futures, it may be worth it.

What does all this mean? You can definitely make money if you have a strong hunch that volatility is going to spike in some period in the not-too-distant future.

But because of the costs and distributions, this is not something you would want to hold for any length of time. It's the kind of trade you would want to make a quick directional bet on.

Whaley agrees that this is for short-term trading bets, and in case you don't get this point, it's spelled out in the prospectus: "Investors who do not intend to actively manage and monitor their Fund investments at least as frequently as each distribution date should not buy shares of the Funds."

Whaley says he has plans to launch many other target spot indices—largely for commodity indices in oil, natural gas, agriculture, and metals.

These products should not need to have the "tail risk insurance premium" the VIX products have, and so they should more closely track the underlying indices, even over longer periods of time. That would be significant.

Is investing in volatility ever going to be an asset class that you can buy along with stocks, bonds, commodities? Tom Lydon, editor and publisher of ETF Trends, told me it might become an asset class if there was something available to buy that correlated to the VIX.

This may or may not be that instrument, but I am doubtful volatility will become a big asset class. What I do believe is that it can be a very useful tool to manage short-term risk, and that, as Whaley pointed out to me, has great value when markets change on a dime on geopolitical and macroeconomic events.

  • Bob Pisani

    A CNBC reporter since 1990, Bob Pisani covers Wall Street from the floor of the New York Stock Exchange.

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