VXX iPath S&P 500 VIX Short Term Futures ETN - Volatility M.I.A
Summary
- Barclay’s packaged volatility play provides traders punctual exposure to market volatility.
- Leveraging volatility’s exposure has broad appeal linked to its negative correlation with capital markets.
- Yet these products are not for the faint of heart – more get-in-get-out trades than long term holdings.
- Not for everyone.
Brief Overview
Rarely do we see real bouts of market turmoil. No, I am not talking about a decline in the S&P 500 to levels not seen since last Thursday, but rather generational capital destruction - the likes of which we thankfully come across rarely.
Of course, the SARS-Cov2 outbreak was a notable last catalyst, drilling world equity markets in 2020. From end February 2020, the S&P 500 took a 30+ day battering, culminating in a ~35% drawdown. This episode was in fact the onset for even greater distortions driven by initiatives to stop the societal and economic hemorrhaging.
But it was not the Great Financial Crisis which saw multi-year negative price action and the wholesale destruction of the world banking system - well, at least what it was at the time.
The Dot.com bust also appears to have left more damaging repercussions (the Nasdaq effectively lost 80% of its value during the period) despite also laying the foundations for the digital revolution which swept the world over the past 20 years.
In fact, in hindsight, it appears capital markets have come off relatively unscathed - from a global health pandemic and an economic backdrop which had all the hallmarks of the next big period of global economic depression. Be careful what you wish for, I guess.
The inverse correlation of volatility ETNs such as VXX is abundantly evident when we contrast against a broad market index ETF such as SPY.
Source: Tradingview
As volatility rises, the correlative power pulls multiple asset classes together as they plunge from the skies at unparalleled speed. Cue (BATS:BATS:VXX) - iPath S&P 500 Vix Short Term Futures ETN, an unlikely parachute in times of turmoil, its sole real advantage being its negative correlation to US and international stocks.
Does this mean the exchange traded note is a worthy long-term holding? Not at all. The product is not for the faint of heart, remaining a tactical trading instrument only.
In times past, many an unwary trader has tempted fate by shorting volatility-linked exchange traded notes, only to be completely wiped out as markets crashed and volatility spiked. Likewise, anyone holding the exchange traded note for the long-term hoping this make-be parachute may easily be deployed would be sorely disappointed as the ETN's structure deteriorates over time.
Volatility linked exchange traded notes remain one of the most difficult instruments to trade in the wider family of exchange traded products. But their specific traits and inherent dangers are well worth being privy to.
Source: Market Chameleon
Product Synopsis
iPath S&P 500 Vix Short-Term Futures ETN provides succinct access to equity market volatility, via near-term VIX futures exposure. The product does have a range of drawbacks - the product tracks poorly the VIX index over time due to underlying product structure and product volatility means that it can single-handedly dish out generational losses, particularly to short holders of the product during times of heightened market turmoil.
An important caveat is that VXX does not represent an investment in the VIX but is rather linked to an index which is made up of a basket of futures. Due to the term structure of futures contracts - and the product's tendency to sell low and buy high (at least in periods of contango) - the note tends to indefinitely trend toward zero, with only reverse stock splits propping the product up from figurative self-implosion.
The focus on short-dated futures does help improve correlation to the VIX, but it remains imperfect. Equally remarkable is the pay-off between tighter correlations in exchange for more meaningful adverse impacts of contango (the figurative sell low-buy high effect). Another important note, no pun intended, is that this is an exchange traded note - which helps avoid tracking errors inherent in exchange traded funds but does suffer from credit risk related to the counter party - in this instance, Barclays Capital. The product does boast some similarities to another product I covered earlier, (BATS:UVXY) so I would invite readers to discover it here.
This ETN is series B of the product line as exchange traded notes are a type of unsecured debt security backed by the credit worthiness of the issuer rather than a basket of assets. ETNs have similarities to fixed income products but have no yield. A noteworthy point is that they, like their bond-like cousins, expire over time, hence the Series B of this issuance. Exchange traded notes are riskier than ordinary unsecured debt securities and have no principal protection.
Year-to-date total returns - VXX iPath S&P 500 VIX Short Term Futures ETN
Source: Tradingview
Year-to-date total returns in VXX shows the products characteristic descent towards zero. We can note 2 comparably important periods of heightened volatility - a spike at the start of February as the 10-year US Treasury started heading north, dragging technology and long duration assets down and a period in May linked to similar interest rate movements.
Product Structure
VXX iPath S&P 500 VIX Short Term Futures ETN tracks the S&P 500 VIX Short-Term Futures Index and the VIX Mid-Term Futures on the Chicago Board Options Exchange. The indices tracked are composed of futures contracts on the VIX index with a daily rolling long position in contracts of specified maturities. The underlying indices, per se, are indices which roll daily to maintain a constant weighted average maturity of the underlying futures contracts.
For those unfamiliar with futures contracts, it is important to note that unlike equity securities, futures contracts by nature, have stated expirations. Therefore, market participants wishing to maintain exposure to a contract nearing expiry will be forced to close the near-term month (by selling the futures contract) and buy the later-dated contract. This essentially is the principal of rolling central to understanding long-term price action. This is a key point as the nature of the futures market has historically resulted in a significant "cost to roll".
Comparative Analysis - VXX v UVXY
Source: Spreadsheet developed by author with inputs from ETF.com, Etfdb and Koyfin
VXX fits neatly into the category of specialized volatility linked ETFs. Unlike its counterpart UVXY, the exchange traded note is not leveraged, explaining the differences in negative year-to-date returns. Options markets readily exist for volatility linked specialized products and provide an opportune way of taking on customized risk exposure to the asset category. Understandably, expense ratios tend to be higher for these products given intrinsic product risk and increased administrative costs.
1-year net flows VXX
Source: etfdb.com
Despite navigating a period where volatility has been artificially suppressed by central bank and government intervention, VXX has attracted considerable fund inflows over a 1-year period. Inflows would suggest a degree of anticipation of future volatility spikes as investors look to build more defensive positions.
Key Takeaways
- VXX iPath S&P 500 VIX Short Term Futures ETN is an exchange traded note allowing investors to take on risk exposure linked to the S&P 500 VIX Short-Term Futures and the VIX Mid-Term Futures indices.
- The product is an exchange trade note - as opposed to an ETF - signifying that while tracking error is not material, the credit worthiness of the product underwriter (Barclays Capital) remains a risk.
- Part of a family of volatility linked products, VXX is best suited to hardened investors who understand the considerable capital destruction risks. The product is a short-term tactical play rather than a long-term holding.
- Shorting volatility linked securities can have disastrous repercussions as we saw during the Volmaggedon episode of early 2018.
- Futures roll is a central product trait. Futures indexes typically have exposure to a front month and a back month. By rolling the product (closing one position to open another), the product is exposed to roll costs. During periods of contango, this also implies a pattern of selling low and buying high which leads to the products self-engineered deterioration.
- Options markets widely exist for these products, including for VXX, which provides an opportunity to limit exposures and customize risk/ reward scenarios.
VXX iPath S&P 500 Vix Short Term Futures ETN makes up part of the increasingly relevant volatility linked securities products. Its product make-up, risk exposures and underlying all make it rather atypical.
Given its ability to explode during times of gargantuan market volatility, it provides traders with opportunity but also with considerable risks which need to be embraced and fully understood before diving in head-first.
This article was written by
Disclosure: I am/we are long VXX. 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.