Volatility Funds Try to Cut Insurance Cost

May.27.11 | About: iPath S&P (VXX)

By Chris McKhann

Volatility-based funds continue to roll out, but new funds -- such one by Lyxor -- are trying to use more sophisticated methods to minimize the cost of insurance.

Lyxor's new [LVOL] is based on the VIX but uses a so-called dynamic allocation to limit the losses because of the negative roll yield. This negative roll yield is what so dramatically effects the oldest of the volatility funds, the iPath S&P 500 VIX Short-Term Futures (NYSEARCA:VXX) exchange-traded note.

The VXX has lost more than 90 percent of its value in the last two years while the VIX dropped less than 50 percent. Much of this is because these funds are based on the VIX futures, as the VIX itself is not tradable.

The VIX futures, for a host of reasons, are usually in contango, with each successive future higher than the previous. This means that the funds lose value as they roll out to the next month.

What the newer funds are attempting to do is mitigate this negative roll yield by borrowing an idea developed in the commodity markets, according to a Financial Times story:

It employs an "enhanced roll methodology that shifts between different maturities of the VIX futures curve depending on whether volatility is subdued or rising. So LVOL invests most of the time in medium-term VIX futures to limit negative roll yields. But if stock market volatility spikes higher, it shifts into short-dated VIX futures.

I have said previously that this idea sounds good but may present some substantial problems of its own.
The idea is to buy volatility, specifically the VIX futures that are most sensitive, as they are rising. If they are rising quickly enough, the fund may be forced to chase, and its own buying may force those futures higher.

We have seen this type of idea in action before. Back then it used the sale of equity index futures in the same manner, selling futures to dynamically hedge declines in the markets, and it was called portfolio insurance. It sounds great, but some things are better on paper than in practice: Portfolio insurance gets most of the blame for the crash of 1987.

So we won't know if this dynamic volatility buying really works in a crisis until the next one comes along. But it certainly is possibile that such funds will make the crisis worse as it tries to limit the effects.