VIXX: Better, But Still Awful
April 26, 2010
The proposed Jefferies VIX ETF has a few advantages over the iPath VXX Volatility ETN. Still, for most investors, it’s a terrible idea.
(If you missed the article on Jefferies filing for a VIX ETF, it was reported on IndexUniverse.com.)
The growth of ETNs linked to the CBOE Volatility Index (VIX) has been the single most surprising story in ETF asset flows recently. Despite losing 82 percent of its value last year, the iPath S&P 500 VIX Short-Term Futures ETN (NYSEArca: VXX) currently has $1.3 billion in assets. Its cousin, the iPath S&P 500 VIX Mid-Term Futures ETN (NYSEArca: VXN), has $680 million, even thought it has lost 58 percent of its value in the same period.
It’s like investors don’t care: Both products have gone straight down since launching in January 2009, and yet investors keep piling into them.
All that might make sense if VXX and VXN were providing some sort of magical diversification benefit or if investors had reason to believe that share prices were going to rebound soon. Unfortunately, neither is true.
For instance, while there’s a great deal of academic literature suggesting that the CBOE Volatility Index itself serves as a good diversification hedge, the ETNs themselves (as well as the proposed ETF) track futures on the VIX, not the VIX itself. The returns investors receive on a rolling futures portfolio are often quite different than the returns of a theoretical (and impossible) investment directly in the VIX index itself..
Regarding performance, there’s an easy argument to make that volatility is due for a rebound. It has crept down toward multi-year lows, despite obvious risks that remain for the economy and the stock market.
But neither the ETNs nor the proposed ETFs will fully benefit fully from any rebound in the VIX. That’s because the market for volatility futures right now is already pricing in the likelihood that volatility will be higher tomorrow than it is today. The Spot VIX is currently trading at 16.62, while May futures are priced at 18.50. In order for VXX (which currently holds the May contract) to appreciate in value, spot VIX must rise above 18.50 next month. In other words, investors need an 11 percent increase in volatility next month just to break even!
It gets worse in July, where the futures are pricing in a VIX of 20.75.
This contango is the most obvious reason VXX has steadily underperformed VIX over the past year. And it’s not a pretty sight.
All that said, I’m excited to see Jefferies launching its new ETF for two reasons. First, Jefferies is proposing a management fee of just 0.49 percent, compared to 0.89 percent for the iPath ETNs. That’s a substantial savings.
In addition, it’s always struck me as odd that investors would buy ETNs linked to volatility. After all, the biggest -- really, only -- concern with ETNs is that they are debt notes with exposure to a potential default by the issuer. The idea that you’re voluntarily taking this risk on in an instrument only designed to make you money when volatility is going through the roof seems odd. The new ETF does away with that problem.
Unfortunately, having a better version of a bad exposure doesn’t do anyone much good. I love the idea of investing in volatility; VIX futures just aren’t a great way to skin this cat.