By Paul Amery
With the VIX (Chicago Board of Exchange Volatility Index) falling to the low 20s, it looks as though risk in the markets is subsiding again for the moment. However, whether the VIX will flatten out for a longer period is an entirely different matter.
Here’s a graph of the index from the beginning of 2007 to last Thursday’s close:
The VIX is often described as the market’s “fear index” and the idea is to sell equities when it’s low (i.e., when investors are complacent) and buy when it’s high (when investors are fearful).
That’s easier said than done. If you had sold or shorted equities in January 2007, when the VIX (unbelievably, in hindsight) dipped below 10%, you’d have had an uneasy wait for most of the year until equity indices hit their high (the S&P 500 index reached its all-time intraday record of 1576.09 on 11 October). If you’d had deep enough pockets and could wait this period out then early 2007 would have been a good time to cut equity exposure.
Similarly, buying equities in October or November last year when the VIX jumped would have taken a great deal of courage in view of the general panic at the time. If you had bought, your nerves would then have been severely tested when the major indices declined further in the first quarter of this year. But, given that markets have embarked on a rally since then, buying at or near VIX levels of 80% would have paid off eventually.
Warren Buffett, anyone? His purchase of US$5 billion Goldman Sachs (NYSE:GS) preferred shares in September looks in hindsight like an inspired move, though even Buffett must have been feeling nervous in November when Goldman ordinary shares hit a low of US$47.41. There was even a mini-panic in March this year that Berkshire Hathaway (NYSE:BRK.A), Buffett’s investment vehicle, might be going bust, when its credit default swap spread hit over 5% per annum.
Now he’s sitting on a nice earner with income of 10% from the Goldman preferreds and warrants to buy an equal amount of common stock at US$115 per share. The bank’s shares closed last night at US$165.45, giving him a very handsome paper profit. The Wall Street Journal calculated last week that he’s up US$2.11 billion on the warrants alone, and his preferred holdings will be well in profit too as credit spreads on Goldman fixed income securities have contracted substantially since September.
Exchange-traded product investors can of course trade in volatility without taking directional bets on the equity market via iPath ETNs on VIX short-term and mid-term futures, launched in January this year.
With the decline in the VIX, these have been a poor investment so far. The indicative value of the iPath VIX mid-term futures ETN (NYSEARCA:VXZ) has fallen 15.65% since its launch on 29 January, while the value of the iPath VIX short-term futures ETN (NYSEARCA:VXX) has fallen 40.25% over the same period.
Most investors seem to prefer VXX to VXZ, by the way. The former has US$320 million invested, the latter only US$18 million.
The surprising difference between the returns of the two ETNs reflects their exposure to different maturities along the VIX futures curve. The VXX return is based on a daily rolling long position in first and second month VIX futures, while the VXZ return reflects a rolling position in fourth, fifth, sixth and seventh month VIX futures.
Because the decline in near-term futures contracts has been more extreme since January, the short-term VIX ETN has suffered accordingly in terms of price. This is the same “roll yield” effect faced by investors in ETFs/ETNs/ETCs based on commodities futures, so it’s worth being sure exactly how these instruments might perform before investing and being aware that your returns will not track the quoted spot VIX levels over time.
Whether we return to a 2007 scenario, when the VIX was flat as the proverbial pancake, is another matter. Perhaps the VIX decline is telling us that we’re approaching a top in equities and it’s time to cut back exposure—or to bargain hunt in VXX.