Searching For The Perfect Hedge With VXX

With US Treasuries trading at super-low yields and gold trading at record highs, many investors are reluctant to use these assets to hedge their equity exposure. While other forms of hedges exist, such as put options, short futures contracts and inverse ETFs, many investors have expressed interest in using the VIX Index as a form of protection.

The VIX Index measures the implied volatility priced into S&P 500 option contracts (calculated using the Black-Scholes methodology). The index illustrates the expected volatility for the S&P 500 Index over the next 30 days.

Generally, market volatility rises with market risk. For this reason, many point to the VIX Index as a way to diversify exposure to risky assets, thereby providing some downside protection during volatile markets. Research suggests that the portfolio benefits of the VIX Index arise during periods of extreme market stress, such as the 2000-02 tech wreck or the 2008-09 financial crash.

While the VIX Index has been around for over two decades, it has been inaccessible to the average investor until recently. In 2009, iShares launched the iPath S&P 500 VIX Short-Term Futures ETN (VXX). This exchange traded note provides easily traded "exposure to a daily rolling long position in the first and second month VIX futures contracts and reflects the implied volatility of the S&P 500 Index at various points along the volatility forward curve. The index futures roll continuously throughout each month from the first month VIX futures contract into the second month VIX futures contract."

While VXX may not track the underlying index perfectly because of the roll costs created by steep contango of the VIX futures curve, it should still provide portfolio benefits during periods of market stress.

The current market mini-crash (see chart below) may be the first true test of whether VXX indeed reduces downside risk.


The chart below shows the effects of adding up to 50% VXX to a portfolio of the S&P 500 Index (indexed to 100). From July 1-Sept. 8, the S&P 500 fell by about 11%. However, as you can see in the chart below, progressive weightings in VXX provided accretive value to the portfolio, with up to a 50% return differential (for a 50% allocation to VXX) from a 100% allocation to the S&P 500.

During this period, only a 13% allocation to VXX was required to maintain the portfolio value at 100. In other words, only a 13% allocation was required to hedge the portfolio. Any allocation greater than 13% added to portfolio returns by effectively providing a net long speculative position on VXX.

During this period the correlation of daily returns between the S&P 500 Index and VXX was -0.89. This is as close to perfect negative correlation that I've ever seen.

In conclusion, during periods of market stress, a relatively small allocation to the VIX Index by using the iPath S&P 500 VIX Short-Term Futures ETN may prove to be a beneficial hedge.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.