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The risks of VIX-tied investing

The Syrian civil war. Economic uncertainty. The China-Vietnam standoff in the South China Sea. High-frequency trading. Any or all of these factors, and many others, can roil markets and cause an upsurge in volatility, which in turn can wreak havoc on an equities portfolio. The fund industry has responded by launching a range of tools that purport to hedge the risk of uncertainty. One of the more popular methods to emerge in recent years is exchange-traded products (ETPs), such as ETFs and ETNs, tied to the VIX, which is the CBOE Market Volatility Index.

Robert Whaley, Vanderbilt professor, “father of the VIX”
Source: Vanderbilt University
Robert Whaley, Vanderbilt professor, “father of the VIX”

Trading in these ETPs ostensibly gives investors an opportunity to profit when the VIX spikes, thereby offsetting potential losses in other areas of a portfolio.

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But there is a major drawback to these products that many investors might be missing. The most popular VIX ETPs are not suitable for buy-and-hold investors because they are virtually guaranteed to lose money over time. In fact, since VIX ETPs first came to market beginning in 2009, they have chalked up aggregate losses in the billions of dollars.

What they are and what they aren't

In 1993, I developed the CBOE Market Volatility Index for the Chicago Board Options Exchange. In 2004 the index was modified by the CBOE. Since its creation, the VIX has become a very popular measurement of market anxiety, spiking during times of geopolitical and economic uncertainty. For example, the VIX spiked to 89.53 on October 24, 2008, on fears of the impending financial crisis.

The first generation of exchange-traded volatility products were launched in the U.S. by the CBOE as futures and options contracts written on the VIX. These date back to 2004 and 2006, respectively. For most investors futures are impractical and as a result the second-generation of volatility products, VIX ETPs, came on the scene three years later allowing wider access to the investing public.

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Since then, both the VIX futures and ETPs have become quite popular. In 2013, VIX futures trading volume hit a record high for the fourth year in a row, at nearly 40 million contracts — a jump of 65 percent over 2012. Last year, average daily trading volume also set a fourth-straight annual record, an increase over 67 percent from 2012. The VIX ETPs have demonstrated similar growth.

Severe downside

But for investors looking to hold VIX ETPs for longer than a very short period, these investments have serious drawbacks. First is the reality of widespread misunderstanding about current VIX products. Many investors in these products believe they are actually buying the CBOE's VIX. Hardly. VIX ETPs are securities created using complex VIX futures trading strategies. Close, but no VIX.

This leads to the second pitfall. Because these strategies demand daily rebalancing, they are subject to high management fees. Add other expenses such as futures commissions, and trading and licensing fees, and it's clear that investors can find themselves in a hole before they even start to consider their returns.

But, even in the absence of fees and expenses, the trading strategies these products follow are destined to lose money from the "contango trap." The VIX futures market is said to be in contango when the futures price curve slopes upward. This situation dissolves VIX ETP returns over time.

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My research found that the price curve sloped upwards on nearly 80 percent of all trading days for futures with 30-day maturities. This erosion happens because the price of longer-dated futures contracts is almost always higher than the price of shorter-dated futures contracts. VIX ETP managers, who base their products on trading these futures, must roll these futures contracts from one month to the next. But as they become more expensive (a "negative roll"), investors are hit with losses each month the price curve stays in contango.

To make matters worse, most VIX ETP investors cannot gauge the magnitude of the losses they will incur because they do not have access to real-time or end-of-day VIX futures prices. Nor do they realize that the mechanistic trading in the ETP makes holders vulnerable to pre-positioning by professional traders relating to the rebalancing of the underlying assets.

What to do

Given this nightmare scenario, what can investors who want to buy and hold VIX ETPs do? First, buy products based on the VIX Mid-Term index, not the short-term index. The price curve tends to be much flatter, and, thus, the losses due to the contango trap are considerably lower – or incurred at a much slower rate.

Second, consider only VIX ETPs that offer interest accrual, whether by benchmarking to the Total Return indexes (such as VXX or VXY) or promising the return of the Excess Return index plus an explicating interest accrual.

Third, keep an eye out for a new generation of VIX ETFs under development. They eliminate many of the expenses and negative roll problems of existing products, and put investors much closer to the VIX index itself. In short, they're ETFs that do what they say they're going to do, providing investors with true spot exposure to the VIX index.

Commentary by Robert Whaley, a professor at Vanderbilt University. He is known as "The father of the VIX" for developing the CBOE Market Volatility Index (VIX) for the Chicago Board Options Exchange in 1993. He is also a partner and special advisor to AccuShares, LLC.

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