How A Volatility ETF Could Work

I read this news that options are being added for more volatility products; the new additions are for the VXN index (Nasdaq 100) and RVX index (Russell 2000).

Every so often someone will leave a comment wishing for a VIX ETF. On the surface there seems to be some appeal, but as Adam Warner notes there are a lot of potential flaws with such a product.

We saw with the Oil ETF (USO) that not every ETF will work, and something as complicated as an ETF to mimic VIX seems like one with a high likelihood to misfire. But if it did work, I might have an idea of how it could applied in a diversified portfolio - its special purpose so to speak.

I would imagine that this would be one of those funds that was 95% T-bills and 5% futures. In eyeballing any SPX/VIX comparison chart the two appear to have a very low correlation; PortfolioScience puts the three month number at -0.889, so almost a perfect negative correlation.

So is there room in a diversified portfolio for something with a negative correlation to stocks that yields 4-5%? Your answer to that question will determine your level of interest.

A notion I have touched on before is that if the US stock market is evolving to have more volatility and slightly lower returns then having a few different things with some yield that have little to do with the stock market (along with some foreign stocks, currencies and commodities) will make sense.

I would expect that most of the time it would bounce around pretty aggressively within various ranges and during times of panic, like we had this summer, it would go up a lot. I think that anytime it did panic higher it would need to be sold and then it would take patience before buying again.

There is a lot of fear that things are somehow going to be different this time around. While I think that is unlikely, if things are going to be different, something like a VIX ETF - should it ever come - could be a good fit in this context.

Comments

[ikkyu]

Greetings Mr. Nusbaum, Do you currently trade or hedge with volatilty? I think this would be a lousy ETF. If you can figure out this hedge ratio, then you can probably buy options. Do you know what the implied volatility of volatilty averages? Right now VIX near the money options for october are between 72% and 88%! I think this is kinda a joke. Please read about Mr. Macdonald's misadventures into VIX: seekingalpha.com/artic... I am sorry to be so harsh, but this is really out there. CHEERS, JOHN

2007 Sep 17 10:04 AM

[ikkyu]

P.S. VIX Does indeed provide a good hedge but VIX futures are a whole different animal. Please see a great discussion at Beta date:www.mktbetadata.blogsp.../ titled "basis risk and premium in VIX futues contracts. Again, this idea is not well thought through.

2007 Sep 17 10:18 AM

[User 27219]

impossible to have a VIX ETF, its a dynamic 30 day forward vol swap. There is no way to replicate it

2007 Sep 17 03:50 PM

[Roger Nusbaum]

maybe an ETN?

2007 Sep 18 11:49 AM

[mitsuo]

How would any ETF sponsor gather assets with a VIX ETF?

2007 Sep 17 09:12 PM

[Roger Nusbaum]

if it worked I think the assets would come. big if on it working of course.

2007 Sep 18 11:49 AM