The Hoax Of VIX = Risk Revisited

by: Peter F. Way, CFA

About a year ago, in September 2012 we showed how the VIX index followed changes in the S&P 500 index (NYSEARCA:SPY), not the other way around. A re-read of the article will provide a recommended refresher for this update.

None of the basics there have changed. Risk is not adequately represented or described by volatility. Historical measures of past market price index change have little timely forecast value in anticipating its future, and only weakly of coming prices for the VIX. Irregularity of market disruptions through time make the timing of VIX investment actions crucial.

At this point we have another year of experience behind us to evaluate what are the better ways to utilize the market-makers (MMs) insights into probable coming price moves in the major market indexes, and how good their insights have been. Some may involve VIX ETFs. A few additional ETFs have been created that may enrich our perspectives over time.

A current market-maker perspective

Here is how the MMs see the prospects of coming price change in the next 3-6 months for the ETFs and the VIX index that are driven by interests in the S&P 500 index.

(used with permission)

New to this list are the S&P 500 Low Volatility ETF (NYSEARCA:SPLV) at [2] and its counterpart, the S&P500 High Beta ETF (NYSEARCA:SPHB) at [5], each trackers of indexes that emphasize the 500's components with the characteristics their names indicate. Unfortunately, while a history is developing for them, their newness has as yet prevented anything of forecast value that we would be willing to commit capital to risk. But they may in time become part of a background fabric more helpful than other ETNs that have no option appraisals.

At the moment, the VIX itself has the most extreme upside-to-downside forecast, at [9], of anything in this set. Items above the diagonal dotted line are being traded at prices seen by MMs as having more downside than upside. Here is how the VIX index's appraisal has trended daily over the past 6 months:

(used with permission)

The vertical lines in this picture should not be confused with familiar high-low-close charts of actual past price ranges in the marketplace. These are a history of daily price range forecasts implied by the self-protective actions of market-makers as they hedge the firm capital that must be put at risk to help big-money fund clients adjust portfolio holdings in large block trades. What the MMs pay for such protection, and the way the hedges are structured, tell the price extents of their concerns. The heavy dots of market price contemporary to the time of forecast split the uncertainty into upside and downside prospects.

MM forecasts for the VIX index typically have good sense of future direction and a fair sense of size of move ultimately, but suffer from the inherent time irregularity of events that become the precipitators of major market moves. That makes investments in the VIX index challenging.

So does the lack of an ETF directly linked to the index, like SPY is to the S&P 500. The several ETPs driven by the VIX typically achieve the linkage by investing in VIX futures. The oldest of them, the iPath S&P 500 VIX ST Futures ETN (NYSEARCA:VXX), has been around little more than 3 years, and invests in a continually rolling proportion of 1-month and 2-month expiration futures to maintain a constant 1-month average pricing posture that mimics the index's price moves. How well it does that is pictured here:

The often persistent, but interrupted, decline in the index is paralleled by a pattern of price differences between futures expiration months, variously labeled "contango" or "normal backwardation" depending on which expirations are higher or lower. Futures speculators attempt to anticipate either persistence or change in these conditions with their trading strategies. The irregularity of events complicates such efforts, although the trend has led some investors to play the effect of its persistence during this rising market.

Another major market tumble would seriously damage positions mentally locked-in by such strategies.

Three other ETPs came into existence less than three years ago. The ProShares Short-term Futures ETF (NYSEARCA:VIXY) also attempts to track the VIX index by using VIX near-term futures positions with results similar to the VXX, but with fewer assets under management and trivially less liquid markets. Also from ProShares is a mid-term ETF based on the mid-term VIX Index (NYSEARCA:VIXM) that measures uncertainty on a slightly longer-term basis. Its assets under management and market liquidity are more restrained.

From another vendor, Velocity Shares comes a VXX-VIXY me-too ETN, (NASDAQ:VIIX) with small AUM and fairly severe liquidity issues.

Because of the stock market's persistent rise from the 2008-9 Mortgage-Backed-Securities (MBS) debacle, the VIX in the past 2-3 years has been under fairly continuous pressure to stay at low levels. That has made a short (inverse) version of the VIX short-term Futures ETF (NYSEARCA:SVXY) an attractive vehicle to profit from the decline pictured in the above comparison of the VXX and the VIX.

The SVXY's history is still short of 2 years, but in that limited time its performance has been highly productive on a static long-term-hold basis, with average annual rates of gain in the +80% to +90% area. When a standard time-efficient strategy of buys at Range Index levels like the present set sell targets of top of forecast ranges and holding period limits of 3 months, truly amazing results have been obtained. They are shown in the comparison table below along with results from the same strategy by all the related S&P 500 volatility products and indexes.

For those new to this analysis, the Sell Targets are the top of the Price Range forecasts, Worst-Case Drawdowns are an average experience of implied forecasts during the last five years' having a balance of upside to downside like today's. That balance is expressed in the Range Index, which tells what percentage of the low to high forecast range lies below the price now. The Win Odds are the proportion of those similar prior forecasts that produced profitable experiences in the 3 months subsequent to the forecast, usually by reaching sell targets. Payoff percent are the geomean gains from cost price at forecast day+1 to a number of (market) Days Held later, in a strategy of closeout at first day's close => sell target or no more than 3 months later. Sample size counts number of such RI experiences in the average data shown.

The Reward to Risk Ratio compares Sell Target Potential to Worst-Case Drawdowns in a conservative, present ex-ante measure.

Experience shows that best returns and strong R~R Ratios associate with high levels of Win Odds. The standout on that basis is SVXY with all of its 11 Range Indexes at a level of ~21 ending profitably. With an average holding period of only 19 market days, obviously all reached their sell targets. The average worst-case downside price stress in the SVXY experiences was only 1/4th the size of its current upside prospect. Further examination (not shown) reveals that even with RIs as high as 40, double that number of experiences were also all profitable in 20 day holdings, at triple-digit annual returns.

The value of a time-efficient strategy over a buy, hold, (and forget) conventional approach is emphasized in the SVXY case where an average of 19 days holds out of 423 possible commitment days meant that the capital was actively employed only 5% of the time, and was available for other employment the other 95%. This fact is what justifies the posting and discussion of 3-, 4-, and even 5-figure annual rates of return, achieved by the compounding of gains several times in a year.

Many in the investment community regard such rate of return displays as flamboyant, even rude, when "everyone knows that equities normal returns are in the 9-10% a year range and very few stocks can show growth trends of +50% a year for several years." Which is exactly why buy, hold and forget can't compete, doesn't compete, and its practitioners feed the wealth builders who instead are employing time-efficient practices.

The equities markets are very noisy when it comes to price movements, due largely to a combination of herd inclinations and serious capital concentrations in a limited number of places. By locking up capital in static investment assignments that are forced to ride through the detrimental periods that position the next price rises, conventional investing practices punish the returns that are the reward for good selections of subjects, with bad selections of holding period times.

But big-money funds can't easily escape from the trap that they build and make worse for themselves. Their fees typically are based on the size of the assets under management (AUM). If they want to make more, they seek to attract new investors, or capital additions from existing ones. That makes their difficulty in adjusting portfolio holdings ever more of a problem in markets with a limited capacity for the large transactions that are needed. In turn, that encourages them to simply sit on held positions rather than try to earn more by active management.

Part of the problem comes back on the investing public itself. It has been sold on the idea that what appears to be modest fees based on AUM is a far better arrangement than having some hedge-fund "hotshot" take 20%-plus of what the investor's capital earns. It turns out that what many Mutual Funds deliver as investment returns after their "modest" fees, are often less than the fees, so the MFs in many cases are getting more than 50% of the gross returns. But the public has an incomplete sense of the reality and keeps on incentivizing the money management community with fees based on AUM. The managers respond by marketing superficial concepts to pull in more capital, which in turn further chokes the markets.

The positive side of all this is that technological advances in communications (importantly via the internet) and in information handling make it far easier for individuals to get information and the means of making sensible comparisons about the prospects of various investment securities. The likelihood for an individual do-it-yourself (d-i-y) investor to be successful for him/herself is greatly enhanced. That condition is magnified when the d-i-y recognizes the transaction flexibility his/her relatively small size affords, and the truly trivial transaction costs available in today's competitive brokerage community. Active investment management can significantly outperform.

Seeking Alpha can be an important resource in that activity, since the largest part of its efforts are directed toward the millions of individual investors hungry for honest help. Its educational articles provide a broad range of subjects and approaches from experienced and knowledgeable people, many of whom have first-hand industry experience to draw from. And they are carefully edited in a disciplined, constructive setting.

We have additional articles in preparation that will elaborate on what time-efficient active management practice can add to the investment scene, both in greater returns and in reduced downside price risk. Also, there are detailed examinations coming of how well MMs have identified the future price prospects of stocks and ETFs. We hope they will be found to be helpful to each d-y-i in building satisfying investment portfolios.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.