Time To Add VIX? A Negative Roll Yield Makes It An Expensive Form Of Insurance

Feb.28.12 | About: iPath S&P (VXX)

Today Prieur du Plessis suggested buying the VIX to hedge equity portfolios. I agree with much of his strategic thinking, and I like his research on the use of P/E ratios. But I would caution investors that buying and holding the VIX is a very expensive form of insurance.

Coincidentally, I recently considered buying the VIX for many of the same reasons that du Plessis pointed out. I got interested mainly because the VIX looks historically cheap below $18. I even told a client that I was considering it for his portfolio, probably through the iPath S&P 500 Short-Term Futures ETN (NYSEARCA:VXX).

Then I did some research, and I read this excellent article from Index Universe: Portfolio Applications for VIX-Based Instruments. (Check it out--you won't regret it.) This made me look at VIX futures, and I changed my mind about buying a VIX product. I wrote a letter on February 21 admitting my mistake. Here it is, verbatim:

Last night after work, I suggested buying the VIX to hedge a long-term portfolio.

I did more research and I would NOT buy the VIX right now. That's because buying and holding the VIX is very expensive at the moment. The VIX is a form of insurance, and all insurance costs money. Stupid me, I jumped the gun and opened my mouth before I finished my research. (I got no problem admitting my mistake - as long as we didn't lose money.)

Anyway, if you look at what is in the VIX fund, you'll find that it's comprised of futures contracts. Every few days a futures contract expires, and the fund manager has to sell today's contract and buy tomorrow's contract. This doesn't matter when futures prices are the same as spot prices.

But right now futures prices are rising more and more each month: The June futures for VIX is $24 and the December futures for VIX is $30. So if volatility doesn't rise, you lose money every time you buy a new contract. That's because you are constantly selling today's contract at $18, and buying tomorrow's contract at $19, $20, $22, $24, or $30. Therefore, the VIX tends to lose money every month when futures prices are rising.

In case you care, the technical word for this is "Contango," which means that futures prices are higher than spot prices. This is true for any futures price, not just the VIX. It could be oil, gold, interest rates, the stock market, or a volatility index like VIX. The VIX is like insurance: You could hit a big payoff, but you have to pay a premium of 6% each month (at least today you do).

The technical name for losing money this way is a "negative roll yield." This happens when futures prices are in contango. In case you are curious, here is the link to the current VIX futures: here.

Right now the roll yield is sharply negative, making VIX prohibitively expensive. Thus, I would NOT hedge with VIX until there is a negative short-term catalyst. Buying and holding the VIX as insurance is too expensive right now. I might buy the VIX later, but not yet.

Once again we learn, always do your research before you buy!

I hope this was helpful - call anytime with questions.

Rob

Bottom Line: I think that du Plessis makes some great points about hedging, but be careful about implementation. The timing and the tools make a big difference.

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

Additional disclosure: Read here