ProShares Launches Two VIX ETFs - Contango Issues Abound

by: Morningstar

By Robert Goldsborough

On Tuesday, Jan. 4, ProShares will launch two exchange-traded funds based on futures contracts tied to the Chicago Board Options Exchange's VIX Index, which reflects near-term market volatility.

By our count, the funds will be the 14th and 15th VIX-related exchange-traded products to begin trading since 2009, and they reflect continued interest by both investors and ETF providers alike in tracking the VIX, which is known by many as the "fear index" or the "fear gauge." The VIX measures the implied volatility of an index of large-cap U.S. stocks over 30 days into the future, and it's a hypothetical calculation of volatility based on the prices of certain call and put options on the S&P 500 Index over the month to come, reflecting the premium paid by investors for certain options linked to the broad benchmark.

Historically, the VIX has had a negative correlation to the S&P 500. So when U.S. large-cap stocks are up, the VIX tends to suffer, and when stocks are down, the VIX rises.

Investors cannot invest directly in the VIX Index; instead, they only can invest in VIX futures contracts. This has prompted ETF and ETN providers to develop a varied set of VIX-themed products tracking short- and medium-term VIX futures contracts.

Now, ProShares, which is known for its leveraged ETFs, has entered the fray, joining providers like Barclays, Citigroup, UBS, and VelocityShares. ProShares' two new ETFs will not be leveraged (or inverse) and will track short- and medium-term VIX futures contracts.

The first new ETF, ProShares VIX Short-Term Futures ETF (NYSEARCA:VIXY), will track the S&P 500 VIX Short-Term Futures Index, whose components represent the prices of two near-term VIX futures contracts, replicating a position that rolls the nearest month's VIX futures to the next month's VIX futures on a daily basis in equal fractional amounts. This gives the index a constant weighted average maturity of one month. ProShares' other new VIX-related ETF, ProShares VIX Mid-Term Futures ETF (NYSEARCA:VIXM), will track the S&P 500 VIX Mid-Term Index, whose components represent the prices of four contracts months of VIX futures, including a rolling long position in the fourth, fifth, sixth, and seventh month VIX futures contracts. This gives the index a constant weighted average maturity of five months.

Both ETFs will charge 85 basis points, which ties them for being the lowest-priced VIX-related exchange-traded products on the market along with UBS E-TRACS Daily Long-Short VIX ETN (NYSEARCA:XVIX), which as its name indicates is a long-short product. XVIX differs from many other volatility-related exchange-traded products in that it tracks an index that measures the return from a 100% weighting in a long position in a medium-term index known as the S&P 500 VIX Mid-Term Futures Index Excess Return and a 50% weighting in a short, or inverse, position in a short-term index known as the S&P 500 VIX Short-Term Futures Index Excess Return. The index then rebalances the weightings of the long and short positions each day, which in theory exposes XVIX less to the steep contango inherent in the VIX futures curve while still giving investors exposure to market volatility.

The steep contango in the VIX futures curve, in fact, is why only sophisticated investors should consider VIX-related exchange-traded products. The two largest VIX-related exchange-traded products, iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX) and iPath S&P 500 VIX Mid-Term Futures ETN (NYSEARCA:VXZ), together have attracted more than $2 billion in assets since their January 2009 launches. However, between generally strong market performance in 2010 and the effects of contango, both iPath ETNs were hammered in 2010, with VXX falling a whopping 72% and VXZ dropping more than 14%. (As a reminder, the S&P 500 finished 2010 up almost 13%.)

Clearly, as markets were up nicely in 2010, investment vehicles that profit from increased market volatility--like VXX and VXZ--suffered. For sophisticated investors with strong conviction that significant market turmoil is ahead (and strong stomachs in the meantime), VIX-themed exchange-traded products could make some sense. For most investors, however, it's probably better to steer clear. VIX-related products like VXX and VXZ track indexes of near-term futures that capture many of the movements of the VIX index but that generally lag the spot volatility index (which investors can't invest in). This is the result of many institutions using these futures to guard against adverse market movements, so the prices of longer-dated contracts include sizable insurance premiums that disappear as they move toward expiration.

The result is a large negative roll yield, meaning that products like VXX and VXZ lose money--in some cases, amazing amounts--during periods of market stability and constant volatility, when investors have some level of certainty about market climate. Also, these futures contracts do not fully participate in spikes in the spot VIX because they proxy for expected future volatility. They likely will be priced higher during periods of low present volatility and lower during periods of high present volatility, due to the asset class' well-known mean reversion. The heavy costs for this insurance make these kinds of products attractive only in small doses and only when volatility trades in the lower half of the historical range.

With its two new ETFs, ProShares surely is eyeing the significant inflows that VXX and VXZ have attracted--and at a slightly lower price tag than the 0.89% that iPath charges for VXX and VXZ. Other alternatives for investors interested in investing in S&P 500 VIX Short-Term and Mid-Term Futures include VelocityShares Long VIX Medium Term ETN (NASDAQ:VIIZ) and VelocityShares Long VIX Short Term ETN (NASDAQ:VIIX), both of which also charge 0.89%. The remaining VIX-related exchange-traded products largely are inverse or leveraged ETNs.

ProShares first filed paperwork with the Securities and Exchange Commission on Nov. 5, seeking to launch the two funds.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.