The Black Swan Hedge: VXX and VXZ in These Volatile Markets

Includes: SPY, VWO, VXX, VXZ
by: Lawrence Weinman

Since I began writing about using the volatility ETNs VXX (short term) and VXZ (medium term) close to a year ago, there has been a fair amount of analysis about the products.

Certainly the effects of contango and the consequent long term decline in the price of VXX have been frustrating to those who have held it.

But these hedges, which I label the black swan hedge, can show their usefulness in times of unexpected political or economic events (black swans). The political upheaval currently in the Middle East and its spillover into the markets has proven to be one of those moments. The horrific Japanese earthquake is another clear example of a black swan with extreme consequences for all aspects of lives and economies.

Due to the large price declines for of these instruments last year, some analysts have written off use of this strategy completely. This is the product of some fairly limited analysis.

  • For Investors these instruments should be a small % of a portfolio as a hedge (insurance) against the damage to the portfolio that occur in periods of market turbulence. As with most hedges, (and most insurance) when the negative event doesn't occur, the hedge loses money. At those times the rest of the portfolio should perform well. Calling hedges like this "born money losers" (see below) is like calling fire insurance a born money loser because most people pay premium their entire life and their house never burns down.
  • When those periods of turmoil do occur, the VXX and VXZ provide a leveraged hedge to the market decline: an "option like" payoff (convexity). Yet unlike an option, these instruments do not have an expiration date when their value can go to zero.
  • Most importantly, writing off the use of a hedge against market turbulence based on one year of steadily rising markets is a clear case of "recency." Recency is the term behavioral economists use for drawing sweeping conclusions based on a small set of recent data.

Nevertheless, one prominent ETF / ETN "expert" (and one prone to extrapolate long term conclusions based on short term data) declared on CNBC at the end of last year:

Red hot exchange-traded notes linked to VIX volatility futures, particularly VXX and VXZ, are born money losers and investors should avoid them at all costs, Matt Hougan,'s president of ETF Analytics, said today on CNBC.

A more sophisticated view appeared in the WSJ just last weekend in an article entitled Will Your Portfolio Survive the Next Survive the Next Surprise. That article included the views of someone with decades of experience in the financial markets who actually manages clients assets, Matthew Tuttle:

"...He's a fan of the iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX), which tends to rise in value when the market's volatility, and investors' fear, jump. This fund has lost 70% in the past year, as markets have rallied, suggesting it can be risky and that investors should keep only a small portion of their portfolio in the fund -- the portion aimed at protecting them from abrupt troubles in the market"

I am certainly in Mr. Tuttle's camp. The events of recent weeks and the impact on the financial markets have shown the value of the black swan hedge using VXX and VXZ as a holding for a very small part of a portfolio.

The political turmoil in the Arab world would qualify as a black swan event, defined by author Nassim Taleb) as a low probability event with extreme consequences. And we are yet to see what impact the horrible Japanese earthquake (surely a tragic black swan) will have on financial markets.

Since February 1 here's how the ETN hedges (VXX short term VXZ medium term) have done vs. the S&P 500 (NYSEARCA:SPY) and emerging markets (NYSEARCA:VWO):

The results demonstrate that:
  • When market volatility hits on the downside, the volatility hedges will move a multiple of the SPY with the leverage (delta) of the VXX higher than the VXZ
  • A relatively small hedge in these instruments can hedge a larger part of the position in the underlying. Here are the moves in the volatility ETNs as a ratio of the move in the ETFs. February 1 through March 10:
  • vs. SPY

    vs. VWO
    VXX 18.8 3.6
    VXZ 12.1 2.3
  • Correlations across equity asset classes go up in volatile down markets with the moves in emerging very often more extreme than in the U.S. market.
  • Even though the VXX and VXZ are tied to the VIX, a volatility index on the SPY, they do usually hedge moves in emerging markets.
  • The case could be made for building a portfolio with a higher allocation to the riskier equity class = emerging, accompanied by a position in the volatility ETNs as a partial hedge. This could boost potential upside gains while limiting some of the downside risk.
These instruments are not for the faint of heart. Below are data for the volatility of the volatility= the volatility (standard deviation of daily prices) of the volatility ETNs over the past 12 months:
VXX 60
VXZ 31

Compare these to the volatility of the equity ETFs:
VWO 20.3
SPY 17.5
These numbers highlight the extreme volatility of these instruments, especially the VXX. So while there is an argument for a core holding in the VXZ, there is also a need to use and monitor these instruments on a tactical basis. Clearly, that makes them tough instruments to use.

Compare the 3 month return (below) to the returns since Feb. 1 (above)

A Look to the Future

The volatility ETNs don’t move in a direct relationship to the VIX (S&P 500 volatility index) because of the contango that hits the VXX particularly hard. But they do track each other, particularly in the short term.

Looking at the charts below, the VIX is trading at just about the levels experienced during the most recent SPY selloff in November - December of last year.

Those who think the market turmoil has run its course would be avoiding or reducing positions in the volatility ETNs and vice versa. The tragic events in Japan obviously add a new element of uncertainty to world financial markets.

Those holding positions in these ETNs as a hedge against their overall portfolio should not fall into one of the behavioral finance pitfalls that lead investors to decide that hedging is a loser’s game. Losing money on a hedge while protecting the value of the overall portfolio is not money thrown away... it is an insurance premium.

The FT published an excellent article on investor complacency towards risk in light of the strong recovery of the U.S. equity markets. Two experts gave excellent insight into the interplay of behavioral finance and the interest among investors in hedging. These are some cautionary words for those quick to dismiss the use of hedging instruments:

“When a market keeps going up and a hedge does not pay off, there can be dissatisfaction, and a feeling that the premium paid for the hedge has been wasted,”....

“When nothing bad happens for a long period, it leaves people’s memories."

Dean Curnutt, Chief Executive Macro Risk Advisers

“.... people become complacent. As a market goes up slowly, implied volatility gets lower and lower, and it can look as if nothing bad is going to happen again.”

Emanuel Derman, professor at Columbia University and a volatility expert, who also works for Prisma Capital Partners.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in VWO, VXX, VXZ over the next 72 hours.

Additional disclosure: Clients of Lawrence Weinman have positions in VXX, VXZ and VWO.