A New Way to Play Volatility

03/03/2009 9:34 am EST

Focus: ETFS

Scott Burns

Director of ETF Analysis, Morningstar, Inc.

W. Scott Burns, director of exchange traded securities analysis for Morningstar, and analyst Bradley Key look at a new fund that may help cushion the blow of volatility.

A new exchange traded note provides exposure to market volatility by following futures contracts on the VIX index. This could provide valu­able insurance for investors to help soften the blow of market turbulence, but you will need to pay up for the downside protection of volatility futures.

IPath S&P 500 VIX Short-Term Futures ETN (NYSEArca: VXX) tracks the Standard & Poor’s 500 VIX Short-Term Futures Total Return Index. This index seeks to replicate the returns on a fully cash-collateralized position in the near-term VIX futures traded on the Chicago Board Option Exchange.

The VIX index is a measure of expected volatility on the S&P 500 Index over the next month. The Chicago Board Options Exchange calculates the VIX index from the prices of the exchange’s liquid options on the S&P 500, but the spot index is not directly investable.

Volatility jumps in sync with stock price crashes, spiking whenever the S&P 500 collapses. This relationship between volatility and price makes the VIX one of the best diversifiers for an equity portfolio. Some assets, like commodities and government bonds, show near-zero correlation, but volatility has a strong nega­tive correlation with stock prices.

Unfortunately, it is also a strongly mean-reverting asset class, so it produces zero long-term return. Any sizable stake in volatility will produce a commensurate drag on returns even as it damps the portfolio’s risk.

But the risk-return trade-off for this ETN is not even as promising as that for the spot volatility tracked by the VIX index. Potential investors should know that the VXX tracks a portfolio of near-term futures on the VIX index, maintaining an average duration of one month.

Because many institutions use these futures to guard against adverse market movements, the prices of longer-dated contracts include sizable insurance premiums that disappear as they move toward expiration, so this ETN will lose money during periods of market stability and constant volatility.

After reaching a record high near 90 in November 2008, the VIX traded in the mid- to high 40s through early February. Equity markets have not seen such high volatility for such a prolonged period since the 1970s.

As the market calms in time, volatility will certainly return to typical values in the 20s. Although these futures can still provide some insurance, they will appreciate from the current rich valuations only if we see another widespread collapse like those in October and November of 2008.

The heavy cost for this insurance [also] means that we would suggest picking up only small stakes when volatility trades in the lower half of the historical range. [And] ETNs carry significant risk because they are debt obligations of backing banks instead of shares in a separate portfolio of assets like traditional ETFs. Barclays Bank, which backs this ETN, has seen extreme distress as its shares lost 65% of their value from August 2008 through January 2009.

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