The ups and downs of ETF volatility

Sharp corrections across global markets have spurred investor demand for volatility products. Emma Cusworth explores the growing range of ETPs covering this area and the risks involved

Volatility trading is still in its infancy, having only emerged as an investable asset class in 2004. Whether it qualifies as an asset class is still a topic of debate, but that has not stopped investors dabbling with the rapidly increasing range of exchange-traded products replicating volatility.

However, with no physical underlying product and trading based on multiple layers of futures tracking the expectation of implied market fear, these instruments are not for the faint hearted. Indeed, volatility is a highly sophisticated and potentially costly portfolio tool.

The vast majority of volatility products on exchange today are linked to the VIX index, introduced in 1993 as a measure of US equity volatility based on prices of S&P 500 options. The VIX is commonly regarded as a gauge of investor uncertainty – the greater the market uncertainty, the greater the perceived risk of a high pay-out for options and therefore the higher the price of those options.

Yet, because it is based on options, the VIX tracks expected volatility in 30 days’ time, not actual volatility.

Rolling futures
As an index, the VIX is not directly investable. ETPs therefore are based on indices derived from the VIX. These benchmarks, such as the widely adopted S&P 500 VIX Short-Term Futures index, use a second layer of futures giving exposure to the expected level of the VIX in one month’s time. It does so by rolling long positions in first and second month VIX futures contracts.

Between December 2005 and August 2010, the S&P 500 VIX Short-Term Futures index showed a historical correlation of 0.87 with the VIX, according to ETP provider Source. Although benchmark indices have shown high correlation to the VIX, they do not have the same performance or risk/return profile and also incorporate futures roll costs.

Nizam Hamid, head of ETF Strategy at Lyxor, said: “Everything is labelled VIX, but there is the initial complication of understanding that there is a big difference between an index that tracks VIX futures versus the VIX itself.”

This is largely due to futures rolling costs. The VIX futures market is usually in contango, reflecting the expectation the VIX will rise. The price of new futures is more than the old contracts are worth. For volatility ETPs to reflect a constant one-month maturity, they must frequently roll VIX futures, so they lose money over the long term.

On the other hand, volatility has a high negative correlation with equity markets. Between December 2005 and August 2010, the S&P 500 VIX Short-Term Futures index had a historical correlation with the S&P 500 of -0.79.

“High negative correlation to equity markets makes volatility an effective downside hedging tool,” said Michael John Lytle, managing director at Source. “Irregular movements cause a spike in volatility so investors can use volatility positions as an insurance against unexpected changes.”

Typically, the benchmark index will only see a positive return if the VIX rises by more than the market expects. Volatility is also mean-reverting so knowing when to sell is crucial.

Due to the roll costs and mean-reversion, these instruments are short-term investments, which should ideally be bought just before a spike in volatility and sold at, or just after, that spike.

For example, as the flash crash hit the US in May 2010 and as European volatility spiked on the back of concerns over Greece’s solvency, Barclays’ S&P 500 VIX Short-Term Futures index total return saw $800m redemptions in one week, almost half its total assets  under management.

A matter of time
Timing is paramount, as volatility is generally fairly quick to revert to the mean. As Ben Johnson, Morningstar’s director of European ETF research said: “The pay-outs for these products come infrequently. Volatility spikes at times of market distress and then mean-reverts very rapidly, usually falling precipitously shortly after the spike. If one has such tremendous foresight to opt into these products immediately before a spike in volatility and get out right at the market top there is a possibility of a large pay-out. The probability of that happening is infinitesimally small however.”

Despite this, there has been significant growth in demand for VIX futures, particularly since March 2009. Market exposure to VIX futures has grown from about $12m in August 2005 to nearly $150m by the end of January 2011.