Challenging yet rewarding

Volatility ETFs are funds providing the ability to trade or invest in volatility as if it were an asset class.

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They do so by purchasing (long exposure) or selling (short exposure) futures contracts on volatility, since spot (cash volatility) isn’t readily accessible.

This can be difficult, since volatility isn’t easily predictable, except when it’s at extreme levels (below 15%, or above 35% to 40%). In those cases, it’s likely that volatility will change direction.

For instance, who would’ve thought volatility would continue to dip this past summer despite the European Central Bank taking a pass on monetary easing?

VIX recently dropped to five-year lows — even though remaining economic concerns justify higher levels.

Let’s look at a brief history of VIX ETFs, their appeal today and the challenges they present for buyers.

VIX measures the implied level of volatility embedded within the price of S&P 500 options trading on the Chicago Board Options Exchange (CBOE) for the next 30 days. In other words, it’s the portion of the price that reflects anticipated up or down movements over that timeframe.

High VIX levels mean people expect a high degree of price variability, while low levels mean people expect less. As such, VIX is often referred to as a fear gauge.

Why VIX ETFs?

Correlations (similar directional price moves of corresponding proportions) have risen on several occasions since 2008.

This left many investors looking for alternative investments (with lower or negative correlations) that provide shelter during periods of overall price decline.

Volatility tends to rise sharply during such episodes — with prices concurrently dropping — so these instruments work for risk diversification (see "VIX versus S&P 500 ETF," this page).

VIX exposure is a potential hedge against long positions. Exposure to this volatile index can provide significant gains, as a result of the price movement it experiences over time (see "VIX: week-over-week percent change," this page).

One example

In the U.S., Barclays iPath launched VXX and VXZ in January 2009. The latest Assets Under Management are US$2.02 billion for VXX; US$201.3 million for VXZ (at August 28, 2012).

The key difference between these two Exchange Traded Notes (ETNs expose their buyers to credit/counterparty risk, whereas ETFs don’t) is in the underlying futures contracts being purchased and rolled over (as they reach expiration) over time. VXX provides exposure to S&P 500 VIX Short Term Futures Contracts, while VXZ seeks to track S&P 500 Mid-Term Futures Contracts, since investors can’t buy VIX on a spot basis.

VIX exposure is a potential hedge against long positions. Exposure can provide significant gains, as a result of the price movement it experiences over time."

Further, exposure to it via futures contracts can prove costly over time because you must roll the contracts over monthly. This is because of contango, a situation where futures contracts trade at a premium that gradually disappears as it reaches maturity. As the futures curve flattens (contango is greater at the front end of the curve), VXZ seeks to minimize contract rolls by investing further out on the curve.

VXX is at risk of greater value erosion (because it rolls contracts over more frequently) than VXZ (which invests in futures contracts further out on the curve, where it’s flatter). The overall trade-off is that VXX provides better traction to spot price movements in volatility (50% to 60% participation over time), compared to VXZ (30% to 40% over time).

When to use VIX

Volatility ETFs do not allow 100% upside participation in VIX because of the use of futures contracts, and the cost of rolling over these contracts through time. Also, leakage in the investment value can occur if you don’t deploy the ETF when VIX is rising. But there is significant short-term upside potential when volatility levels spike.

Canadian ETFs

There are three ETFs from Horizons that provide exposure to VIX.

• HUV – HBP S&P500 VIX Short Term Futures ETF
• HVU – HBP S&P500 VIX Short Term Futures Bull Plus (2X leverage daily reset) ETF
• HIV – HBP S&P500 VIX Short Term Futures Inverse ETF

Horizons launched HUV and HVU, which provide long volatility exposure, in December 2010. HIV, which rises when volatility declines, was launched April 2011. The latter benefits from value leakage over time.

Overall, these fast-trading vehicles aren’t for the buy-and-hold crowd, and haven’t garnered the levels of assets of their U.S. counterparts ($56.5 million AUM for all three at August 29, 2012), since some investors aren’t familiar with volatility as an investment tool. Also, it’s challenging to make money with this type of ETF, given that exposure is secured.

HVU provides the highest potential, but is also the riskiest because its use of leverage is reset daily. Interestingly, it’s the one investors seem to favour, much as VXX is favoured in the U.S. This focus on near-term volatility speaks to people’s desire to capture spot VIX moves, as opposed to mitigate minor losses — and confirms the speculative nature of VIX investments.

Yves Rebetez, CFA, is managing director of ETFinsight.

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