A Flawed Play on Volatility

05/25/2010 11:13 am EST

Focus: MARKETS

Scott Burns

Director of ETF Analysis, Morningstar, Inc.

Scott Burns, Morningstar’s director of ETF analysis, and analyst Bradley Kay say an ETN that tracks the VIX volatility index is a good concept, but has some real problems.

Volatility jumps in sync with stock-price crashes, spiking whenever the Standard & Poor’s 500 index collapses. Expected volatility serves as a proxy for the amount of uncertainty in the market.

When investors are fearful and uncertain, they will demand higher expected returns and thus pay less for assets in the present. This relationship between volatility and price makes the VIX one of the best diversifiers for an equity portfolio.

Volatility has a strong negative correlation with stock prices. Unfortunately, volatility 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.

After reaching a record high near 90 in November 2008, the VIX traded in the mid-30s by May 2009. Thereafter, it steadily declined to a low of 15 in early April 2010 before spiking again to 35 in early May 2010. Equity markets have not seen such high volatility for such a prolonged period since the 1970s.

As volatility has risen substantially in the opening days of May, investors may be revisiting iPath S&P 500 VIX Short-Term Futures ETN (NYSEArca: VXX).

VXX tracks a portfolio of near-term futures on the VIX index, maintaining an average duration of one month. This captures many of the movements of the VIX index, but has a few major drawbacks.

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. This produces a large “negative roll yield,” so this ETN will lose money during periods of market stability and constant volatility.

The fund rose more than 25% in the first five days of the month, but its one-year performance ended May 5, 2010, was a horrendous negative 74%.

Part of the poor performance was due to declining volatility, but a substantial portion was also due to the “negative roll yield” from the continuous purchase of expensive futures contracts.

[Also,] exchange-traded notes carry risk because they are debt obligations of backing banks instead of shares in a separate portfolio of assets like traditional ETFs.

This ETN charges an annual fee of 0.89%, which is comparable to other portfolio hedges with negative correlations to the market such as inverse ETFs. This ETN also avoids the tax consequences and extreme risk of the inverse ETFs, reducing the effective costs of holding the fund.

The only other exchange-traded product investing in volatility is this fund’s longer-dated sibling, iPath S&P 500 VIX Mid-Term Futures ETN (NYSEArca: VXZ). The mid-term contracts tracked by VXZ provide less exposure to the sharp movements of current volatility, but in return they have a less-negative “roll yield.”

It essentially promises less insurance than VXX in return for a lower drag on returns during bull markets.

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