Introduction: A newly-popular form of portfolio insurance appears to be exchange-traded notes (ETNs) based on the VIX, options on the ETNs, and other volatility-related vehicles. Bloomberg.com described the phenomenon a few days ago this way:
Investors trying to protect against declines in U.S. stocks have spurred record demand for securities tracking equity volatility and traded more VIX options than ever before.
Shares outstanding of the iPath S&P 500 VIX Short-Term Futures ETN (VXX), a security designed to rise when stock fluctuations increase, have tripled this year, reaching a record 99.9 million on Aug. 5. Call volume on the Chicago Board Options Exchange Volatility Index rose to 1.12 million on Aug. 6, the most ever and about five times more than put trades, data compiled by Bloomberg show...
For the VelocityShares Daily 2x VIX Short-Term ETN (TVIX), the number of shares outstanding has climbed six-fold to a record 86.2 million this year, data compiled by Bloomberg show. The security is the second most-traded note that profits from gains in U.S. stock volatility.
There is more in the article worth reading. This article explores this phenomenon, focusing on VXX. Note that VXX can be purchased on the NYSEArca and also has puts and calls on it, whereas the TVIX also trades on the NYSEArca, but has no options on it.
Background: The Chicago Board Options Exchange (CBOE) Volatility Index (VIX) is computed via a complex formula. It relates to options on S&P 500 stocks. Investors often gain exposure to the "500" via the S&P SPDR 500 ETF (NYSEARCA:SPY). Vehicles related to the VIX, such as VXX, allow owners of SPY, or leading stocks that comprise SPY, to hold the index and hedge against a bear move without selling their SPY position or putting their ownership of it at risk by selling covered calls against it.
The VIX does not directly relate to stock prices or their expected movement. Other indices, the VXN and VXD, relate to options on NASDAQ and DJIA stocks, respectively.
A general description of the VIX runs as follows:
The CBOE Volatility Index, or VIX, is a measure of volatility based on real-time quotes of S&P 500 call and put options. Sometimes called the "fear index," the VIX measures expected fluctuations in the index corresponding to the current bid and ask for index options of the nearest two expiration months. The mathematics behind the VIX calculation is rather complex, but the final result is a smooth, weighted figure that expresses the range of volatility in the S&P 500 for the next 30 days, a measure called "implied volatility."
Is buying volatility is a good way to hedge against a sharp stock market decline? This article focuses on the VXX to answer that question. There are real problems here, it turns out:
Some problems with the VXX include the following.
1. It's inherently risky: The VXX is an exchange-traded note. From the sponsor's description of the VXX (page 7, sponsor's highlighting):
The ETNs are riskier than ordinary unsecured debt securities and have no principal protection.
Credit of Barclays Bank PLC. The ETNs are unsecured debt obligations of the issuer, Barclays Bank PLC...
Barclays itself has been found to be a weak sister, financially-speaking, by a British regulator, the PRA.
2. VXX is not the VIX (and the VIX is not the stock market): From the same disclosure as above:
Your ETNs Are Not Linked to the VIX Index... your ability to benefit from any rise and fall in the level of the VIX index is limited...
3. Relatively weak negative correlations between the VXX and SPY have existed (from a different document from the sponsor):
Correlations (as of 3/31/2013)
S&P 500 Dynamic VIX Futures TM Index TM Index 1.00 S&P 500 -0.51 MSCI EAFE Index -0.38 MSCI Emerging Markets Index SM -0.49 Barclays US Aggregate Bond Index 0.38 Dow Jones-UBS Commodity Index Total Return SM -0.12
With only a -0.51 correlation with the underlying index, this is not an ideal hedge.
4. Individual portfolios may not track the SPY: The more a portfolio is tailored to the preferences of an individual or a fund manager, the lower the correlation of VXX to the portfolio will likely be.
5. Need for protection may be exaggerated: While it is true that protection is a bit cheap (not unreasonably-priced) right now, VXX may be unnecessary "insurance". Stocks compete with bonds as long-term stores of value. Short-term fluctuations in trading prices do not really matter, and do not need hedging. There is no need to provide a profit to Barclays or a broker to buy VXX if one is truly an investor. If an investor believes that stocks are truly overpriced, then other strategies than a volatility-related vehicle would appear to be more appropriate, focusing on more than just a month or two in the future.
If one is so highly-leveraged that a downdraft, even a sharp one, will seriously harm one's portfolio, one may wish to consider adjusting that degree of leverage rather than adding VXX, with all its inherent uncertainties and complexity.
And, as was pointed out above, the VXX has not been tightly correlated with the SPY.
6. Market downdraft possible without VIX/VXX spike: What happens if the SPY begins to erode in a low-volatility manner? The VIX and VXX may be relatively unchanged, but stocks will still be down. Thus the VXX may not adequately hedge undramatic but meaningful declines in the SPY.
Discussion: VXX is a flawed hedging vehicle. As far as speculating with it, I have no comment; it is what it is.
At this point, the profusion of volatility vehicles means that the field has been picked over by the best mathematicians in the world, using the best computers in the world. The pros are all over these vehicles; that may be a point that non-professionals want to consider before spending money to own them.
Comparison to 1987: Investors famously tried to protect their stock market gains in 1987 via "portfolio insurance". Robert Shiller examined this in a paper for NBER in 1988. He pointed out that the Brady commission defined portfolio insurance as the use of shorting stock market futures based on "computer-based models derived from stock options analysis". Options analysis may have contributed to the 1987 crash, and here we are again with enriched investors piling into options-related hedging vehicles after a multi-year stock market rally.
Monetary conditions are certainly different from those in 1987, but one thing is similar. The rate on the 10-year T-bond had collapsed in 1985 and bottomed in 1986 at what appeared to be the unduly low rate of 7%. Between March and May 1987, it rose rapidly to nearly 9%, settled back, then spiked by October to over 10%. The 30-year bond moved similarly. There was no SPY then, and the S&P 500 peaked on August 26, and did not begin to collapse until its October 5 peak, two weeks before "Black Monday", Oct. 19.
One more move upward in interest rates would roughly replicate the pattern of the 1987 long-term rate scenario, at lower levels. If that occurred, how might stocks react? Would they head down as in 1987?
If so, what might occur if the SPY fell faster than the VXX rose, and many investors saw that they were not as hedged against a bear market as they had expected? Would they then pile in to belatedly sell the SPY?
I cannot answer the above questions; I wonder how many retail investors who may be piling into the VXX, TVIX, etc. really understand what they own and have thought about these possibilities.
Conclusion: In general, vehicles such as the VXX are not necessarily what the public believes they are, and appear to have flaws as classic hedges against a short-term bear move in stocks. I believe, though, that it is reasonable to expect that directionally, the VXX will provide some degree of hedge in a meaningful stock price swoon.
Old-fashioned puts and calls may serve the purposes of hedging an appreciated portfolio better. These could be used either on the SPY or other indices, or on individual stocks.
I wonder if the widespread adoption of the VXX, TVIX etc. may possibly contribute to unforeseen market moves, perhaps if investors begin to find that they are not hedging against an ongoing downdraft in stock prices as they had expected.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Not investment advice. I am not an investment adviser. Also note that I am not an expert in volatility-related vehicles. This article reflects my understanding of matters as of the time of submission to Seeking Alpha. Please do your own research on any decisions related to this article.