Nick Cherney, CFA, is the CIO and co-founder of VelocityShares LLC, the index company behind many of the exchange-traded products that offer exposure to volatility. Nick recently took time out of his schedule to discuss the nuances of futures-based VIX investing and the potential appeal of this asset class:
ETF Database (ETFdb): The CBOE Volatility Index, better known as the VIX, has been around for almost 20 years, and is a widely followed benchmark. But the idea of investing in volatility and volatility as an asset class is a relatively new concept. What has made it possible to invest in volatility?
Nick Cherney, CFA: The VIX has certainly been followed for quite a long time, but even now there are a lot of investors who do not necessarily understand what it is or how it is calculated. It is designed to represent the volatility of the underlying index, the S&P 500. Volatility is a statistical measure, and that means that the VIX is not a replicable exposure; there is really no way to generate VIX returns. The VIX is really a theoretical construct whose value is derived from option prices, but which can’t actually be invested in directly.
What has happened recently that has driven some of the product innovation is the introduction of options on the VIX, as well as futures linked to the VIX. And those are the events that have driven access and interest in the VIX, not only as a theoretical construct, but as an investment tool as well. To give you an idea of how this market has grown, in early 2009 VIX futures were trading at less than $50 million a day. Today they average well over $500 million a day, and on days like we have seen recently where the VIX jumps significantly, it is not uncommon to see the futures volume jump to well over $1 billion traded. So it certainly has been an innovation in investability over the last two or three years.
ETFdb: What is the potential appeal of volatility as an asset class? How has volatility performed historically relative to stocks and bonds that might make up most traditional portfolios?
NC: This is another interesting but potentially not well understood area. The thing that draws most investors into the VIX and related volatility products to begin with is primarily the historical negative correlation to stocks. Not only does the VIX historically have a negative correlation to equities, but that negative correlation is much larger in magnitude when the market moves down than it is when the market moves up. On the surface, that really makes the asset class interesting to a lot of investors.
The one item that they need to remember is that the VIX itself is not directly investable. So most of the instruments out there today are really providing exposure to VIX futures, not the spot VIX.
While a lot of the correlation benefits are certainly still represented in futures returns, it’s not quite the same thing as exposure directly to the VIX. For example, the short-term futures index has a daily beta of about 0.5 to spot VIX, whereas the mid-term futures index has a daily beta of about 0.2 to the spot VIX. The investment vehicles themselves are different, and it is important to note that while the correlation benefits are certainly there, there are complexities around investing in volatility futures that make the asset class slightly more complicated than others.
ETFdb: The VIX futures market is often in steep contango, especially in the short term. How does that impact the relative performance? And how can investors take the other side of the contango phenomenon?
NC: The investing public in general over the last five to 10 years has become more familiar with futures-based investing, and that has primarily been a result of the introduction of commodity ETFs and ETNs into the market. And certainly in oil, a lot of investors became intimately familiar with the issues of contango. Like commodities, the VIX futures sometimes trade in contango, and sometimes trade in backwardation. And what that means for investors is that sometimes an investment in VIX futures will outperform a theoretical investment in spot VIX and sometimes it will underperform it.
The concept that is probably most interesting in the VIX futures space is really more of a recent development since early 2009 when the first ETPs linked to the VIX were introduced. Since then, the futures market has been consistently in a state of relatively severe contango. For 2010, the short term futures index had about a 50% roll cost. In other words, there was a 50% underperformance relative to spot VIX, and the overall index was down about 70%. That is obviously pretty substantial. The mid-term futures don’t suffer nearly as much; that index outperformed spot VIX by about 22% in 2009 and 5% last year.
Those are numbers that are so large that it really is impossible to understand investing or trading volatility instruments without understanding the futures curve. So that has a couple of practical implications. The first is that investors who thought of short-term futures based products as buy-and-hold investments experienced some pretty severe underperformance last year. There has definitely been a developing trend toward thinking of the short-term futures exposure as a much more tactical instrument - more of a trading instrument - than as a long-term buy-and-hold investment.
The other situation that has developed relates to the mid-term futures index, which a lot of investors didn’t initially find as appealing thanks to a lower sensitivity to spot VIX. However, the popularity of this vehicle has risen as a way to try to gain long-term exposure to changes in the level of VIX, while not suffering the same extreme degree of contango that we have seen in the short-term products.
You also alluded to the inverse VIX products and how those work. The first and only daily resetting VIX product was launched at the end of November. For investors who believe that the steep contango in the futures market is a structural event that is going to persist into the future, a resetting inverse VIX product enables them to express that view and be short that roll yield - the same yield that caused the short-term VIX index to lag the spot VIX by about 50% last year. That is really the driving interest for longer term investors who want to look at inverse VIX products. Of course, we also see many of the typical trading strategies being employed, simply for those who want to have short exposure to the VIX on a much more directional basis.
ETFdb: So an inverse VIX product has the potential to be up even when the VIX is up by essentially allowing investors to exploit contangoed markets?
NC: Yes, investors are certainly using it that way. For example, the VIX is, on a spot basis, more or less flat since the end of November, but the daily inverse of the short term futures index is up around 30% during that same time period. Short-term inverse VIX products track the inverse moves of the short-term index, which has a beta of about 0.5 to the daily moves of the spot VIX. So, for a daily resetting product, on any given day it is pretty likely that the underlying index is moving in the same direction as VIX, but over a longer time period - so long as the futures curve remains contagoed - that index will tend to underperform the VIX pretty dramatically. The other factor to consider is that, if an instrument is daily resetting, that has some return implications. Obviously a lot of investors have grown, by leaps and bounds, over the last four years in terms of their understanding of daily resetting products.
A lot of the attention on those products has been around the potential for them to dramatically underperform a direct leveraged exposure to the underlying asset. So for example, it is perfectly possible that over some holding period, an underlying index might be up 10%, but a leveraged daily resetting product may be down over that period. So that’s really where the focus has been, and that certainly comes into play with daily resetting products linked to the VIX as well.
The interesting thing is that under certain circumstances, the effect works in the opposite direction, and those circumstances generally are where you have strong trending markets. In those situations, a daily resetting product will often outperform a simple leveraged exposure. For investors who believe that the negative roll yield in the short-term futures causes a very strong negative long-term trend in the index, it certainly is possible that a daily resetting product could significantly outperform a non-resetting exposure over that time period.
ETFdb: You mentioned before that investors who view volatility as a buy and hold asset had been disappointed by recent performances. How long should investors be comfortable holding these volatility products?
NC: That’s probably the million-dollar question. Obviously many investors are attracted to volatility because they are interested in its negative correlation to equities, and they are interested in how it might help improve the risk/return profile of a portfolio. But as we talked about, the cost of holding a rolling futures position can be quite high, so actual implementation is very difficult. There are certainly many investors out there who are implementing long-term strategies, but we really focus on sophisticated traders and leave those kinds of decisions to them. There is no doubt that it is very difficult and takes a lot of knowledge to really pinpoint what the appropriate holding period is for any given investor.
ETFdb: What happens to these VIX products when volatility spikes? What can be expected if we see another spike in volatility along the lines of what we saw in late 2008?
NC: The last really big volatility spike saw the VIX jump over 175% in a month, and we have not seen anything like that in the past few months. But we have, within the last two months, seen two different VIX spikes, one in late January of around 25% and one more recently of over 30%. It is interesting to note that those two days were two of the most significant negative performances in the S&P 500 in the past year. And on both of those days, two times exposure to the short term futures index would have outperformed any open ended product in the U.S.
For day traders curious about what might happen when the VIX spikes, those are very interesting examples. But the other thing that I think many more people have been looking at is what has happened to inverse VIX products during those two spikes. As I mentioned before, they declined substantially on both of those two days, but overall the inverse VIX products are up since the end of November, the VIX is roughly flat, and some inverse products are up around 30%. Predicting what will happen in volatility is a business we are not in. The volatility of volatility itself is extremely high, and that’s part of what makes these products appealing to a lot of sophisticated traders.
Disclosure: No positions at time of writing.
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