The VXX is an ETN designed to track VIX futures. Investing in VXX is essentially equivalent to exposure to daily rolling long position in the first and second month VIX futures contracts. An investment represents the implied volatility of the S&P 500 at various points along the volatility forward curve. What is the relationship between VXX and VIX?
YTD correlation to VIX (July 31): 0.92 (click to enlarge)
Correlation with S&P: -0.85
VXX return = -31%
VIX return = 17.2655%
Basically, VXX is not meant to track VIX, it is designed to track VIX futures, WHICH IS NOT THE SAME! The reason I ran a quick correlation and wrote this post is because I’ve noticed a lot of blogs complain how the VXX does not accurately track the VIX index. And that’s because it’s not supposed to.
While volatility has grown into a popular, yet important asset class, one must be careful before attempting to use VXX to represent the fear index in portfolio construction (click to enlarge).
Although we can see that the general dispersion of returns for the two have a healthy correlation, there are vast differences in overall returns.
Here’s a look at month by month scatter plots for 2010 (click on each chart to enlarge):
r=.844492 VXX=-3.27% VIX=22.85%
r=.897637 VXX=-12.83% VIX=-13.68%
r=.752518 VXX=-18.06% VIX=-8.67%
r=.94544 VXX=0.9% VIX=28.72%
r=.964911 VXX=40.58% VIX=58.84%
r=.968111 VXX=3.35% VIX=-2.81%
r=.765432 VXX=-26.96% VIX=-28.48%
Further analysis suggests that historically VXX captures about 50% of the daily move in the VIX (although YTD=85%, most likely due to record high implied correlations), largely explained by mean reversion. Theoretically, the VIX index should outperform during a rally because traders will NOT anticipate the VIX to be higher in 30 days. Therefore, the VXX would underperform and get crushed. The opposite would be true in bear markets.
In summary, to say that VXX is a terrible ETN would be inaccurate, there is no mispricing between the two entities. VXX will perform worse than the VIX under the conditions that the market anticipates lower volatility in the future. Unless you are a futures trader, the best way to hedge may simply be buying SPY puts or put spreads. Looking at the metric from a total return basis, we can see the lack of support.