Volatility ETFs: Buy Or Sell Now?

by: Zacks Funds

Volatility in the stock market is represented by the CBOE Volatility Index (VIX), also known as the fear gauge. This tends to outperform when markets are falling or when fear over the future is high. Notably, VIX has risen 9.6% over the past one-month period, reflecting that worries over the stock market have started to build up.

Will the fear level continue to rise and push up the index?

What is Pushing Fear Levels?

After an impressive comeback, the S&P 500 and the Dow Jones dropped for the third consecutive week, representing the longest streak of weekly declines since January's market meltdown. This slump has wiped off most of the gains from these indices, pushing the year-to-date gains down to 0.1% for the S&P 500 and 0.6% for the Dow Jones. The decline resumed after a spate of downbeat data across the globe, in particular China and the U.K., that brought global growth worries back on the table.

Additionally, the growth momentum in the U.S. has slowed down and investors' faith in central banks' ability to boost growth across the globe has faded. Further, signs of sluggish growth in Europe and Asia, a pullback in industrial metals, the oil price drama, and Fed's uncertain policy continue to weigh on stocks. This is especially true as Friday's solid retail sales data for April reignited the case for two interest rates hikes this year while the weaker-than-expected April payrolls data early this month cast doubts over the health of the economy and pushed back the chances of a rate hike.

The latest round of selling last week followed a slew of disappointing earnings reports from retailers that sparked off concerns over consumer spending. All these factors flared up volatility, pushing the volatility index higher.

As per the ft.com, investors pulled out about $7.4 billion from global equities last week, sending the total outflow of five weeks to a five-year high of $44 billion. This reflects weakening faith in the global equity markets. Moreover, the International Monetary Fund (IMF) once again cut its global growth forecast to 3.2% from the earlier projection of 3.4%, citing that the ill effects of a persistent slowdown in China and lower oil prices have spilled over into emerging markets such as Brazil.

The agency also highlighted economic weakness in developed countries like Japan, Europe and the U.S. This could lead to poor stock performance across the globe, providing further support to the volatility index.

Against a woe-begotten backdrop, investors could look into volatility products that have proven themselves as short-time winners in turbulent times. They can use these products for hedging purposes to ensure safety when the stock market starts to plunge.

Volatility ETFs in Focus

A popular ETN option providing exposure to volatility, the iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX), sees a truly impressive volume level of about 73.3 million shares a day. The note has amassed $1.6 billion in AUM and charges 89 bps in fees per year. The ETN focuses on the S&P 500 VIX Short-Term Futures Index, which reflects implied volatility of the S&P 500 Index at various points along the volatility forward curve. It provides investors with exposure to a daily rolling long position in the first and second month VIX futures contracts. VXX shed 7.4% over the past one-month period.

Two more products - the ProShares VIX Short-Term Futures ETF (NYSEARCA:VIXY) and the VelocityShares VIX Short-Term ETN (NASDAQ:VIIX) - also track the same index. VIXY has $252.7 million in AUM and sees good average daily volume of more than 3.4 million shares while VIIX is the unpopular one of the two with just $9.1 million in its asset base and good volume of around 304,000 shares per day. While VIXY charges 85 bps in annual fee, VIIX is costlier, charging 0.89% annually from investors. Both products are down 7.3% in the same time frame.

Another product - the C-Tracks ETN on CVOL (NYSEARCA:CVOL) - linked to the Citi Volatility Index Total Return, provides investors with direct exposure to the implied volatility of the large-cap U.S. stocks. The benchmark combines a daily rolling long exposure to the third and fourth month futures contracts on the VIX with short exposure to the S&P 500 Total Return Index. The product has amassed $2.2 million in its asset base while charging 1.15% in annual fees from investors. The note trades in a relatively lower volume of about 147,000 shares per day and lost 5% over the past one month.

Technical Look

However, when we took a closer look to the technical charts, we found that the volatility index and the ETFs would remain range bound at least in the near term.

In the chart below, we have considered the price movement of the ultra-popular VXX. The ETN touched its 52-week low of $14.64 on May 11 and its short-term moving average (9-Day EMA) is well below the mid and long terms (50- and 200-Day EMA), suggesting some pessimism for the product. Additionally, the bearish trend is confirmed by the parabolic SAR, which is currently trading above the current price of the fund.

However, the Relative Strength Index (RSI) has been rising lately and currently stands at 42.97, indicating that the fund has clearly moved away from its oversold territory, reflecting some potential upside.

Bottom Line

Given global growth fears as well as mixed technical signals, it seems prudent for investors to wait until the stock market falls or more fear factors creep into the picture.

Further, investors should note that these products are suitable only for short-term traders. This is because most of the time, the VIX futures market trades in a condition known as 'contango', a situation where near-term futures are cheaper than long-term futures contracts. Since the volatility ETFs and ETNs like VXX must roll from month to month in order to avoid 'delivery', the situation of contango can eat away returns over long periods.

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