Doing What It Says on the Tin: The Value of Volatility ETPs
Portfolio hedges don’t come cheap, but we shouldn’t confuse those costs with the vehicles that make hedging possible.
Volatility has been written about as an asset class at least since the early 2000s, but not until VIX futures and exchange-traded products (ETPs) attracted substantial volume late in the decade did volatility become a tradable asset for investors who weren’t willing or able to trade options.
In a recent article for this site, Sverre Rørvik Nilsen presents some criticisms of VXX, the most actively traded volatility ETP. In what follows, I’ll explain why the most common criticisms of volatility ETPs are misguided.
VXX is an exchange-traded note (not an ETF, an exchange-traded fund) that provides exposure to the value of the S&P 500 VIX Short-Term Futures™ Index Total Return, a one-month constant-maturity index that tracks a portfolio composed of first- and second-month VIX futures. Because it is so popular, VXX has received the most critical attention in recent years; but because most of the arguments that critics have levied against it apply in some form to any product that trades volatility, we should all have a clear understanding of the advantages and disadvantages of the products before dismissing them as destructive.
My view is that in the presence of a large volatility risk premium,1 a perpetual and static “investment” in volatility will be unattractive for most investors, regardless of whether capital is allocated to put options, volatility futures, volatility ETPs, or related products.
Historically, the costs of owning static, volatility-based portfolio hedges have been greater than their benefits during market crises; criticisms of VXX are often just misdirected restatements of that fact, confusing the trading vehicle with the underlying risk aversion in the marketplace. Although static hedges are often too costly, many investors find dynamic hedges and tactical long–short volatility trading strategies attractive.2 Therefore, understanding the criticisms and rebuttals presented below is essential to avoid confusing volatility ETPs with the fundamental risk aversion they track—and also to make sense of the continually rising popularity of these products.
The most frequent criticisms of VXX, with my responses, follow.
VXX doesn’t track the VIX
This claim is often presented as a criticism, but neither VIX futures nor any volatility ETPs comprising them are intended to achieve returns equal to changes in the spot VIX level. Just as futures on commodities often trade at prices different from the spot price for the commodity, VIX futures—and thus the ETPs composed of them—typically trade at prices other than the spot level. In both cases, futures prices reflect factors that are not present at the spot level, such as carrying costs, interest rates, and fundamental economic factors that drive the price of the underlying asset.
VIX futures faithfully converge to the final settlement value at expiration. VXX faithfully tracks the index of a portfolio composed of those first- and second-month futures. I’m not sure why traders would expect to be able to buy a product that replicates changes in a 30-day weighted set of strips of SPX option-implied volatilities (i.e., spot VIX), because no volatility ETP prospectus has ever offered such a thing. Instead, VXX does exactly what it promises in the prospectus.
The value of VXX decays over time, and the term structure of implied volatility imposes costs on VXX owners
We can grant that these claims are completely true, but to regard them as criticisms misses the point.
The cost of carry and the change in price as an asset rolls down the term structure are not phenomena that ETP issuers invented to cheat investors. They are facts of life for any asset with a maturity date. In an efficient market, any claim on some asset will be priced to reflect the time value of money. And any contingent claim will be priced to reflect uncertainty about the future value of that asset. There are different theories about the causes of term structures in financial markets, but the basic intuition is that the more distant the maturity date, the more uncertainty will be reflected in the asset’s price because investors demand more compensation for bearing that uncertainty. As time passes and expiration gets closer, a VIX futures contract converges to its expected final settlement value, just as a maturing bond converges to its par value.
It may happen that a given VIX futures contract is priced too low or too high, just as a given bond, for example, may trade at too great a premium/discount, creating opportunities for traders. Given the right risk perceptions among market participants, there may even be large, persistent opportunities. But the basic facts about time and uncertainty would only be flaws in the presence of a financial asset whose prices are insensitive to those facts. There is no such asset.
VXX is the amateur version of what professionals trade
Many professionals I know trade shares and options of VXX and other volatility ETPs regularly in their roles at asset management firms, hedge funds, and other institutions. Nilsen lists several assets as examples of preferable alternatives to volatility ETPs, but it is worth mentioning that all of these are subject to the same points discussed above. None of them track spot VIX (again, so what?), and all incur costs related to time and uncertainty:
- VIX/VSTOXX futures and options. “If investors trade these indices through options, they can have unlimited upside, a hedge against losses, or a hedge for a certain interval, such as for a volatility jump from 15% to 18%.” These features also apply to VXX, which does not have capped returns and has often varied inversely with equity market returns more frequently than the spot VIX has. A constant-maturity product like VXX is also arguably better for targeting smaller volatility jumps because it suffers less from path dependency than a single VIX contract held to expiration.
- Delta-hedged at-the-money straddles. I agree that this sort of execution is out of reach for many investors, but selling straddles and hedging delta exposure is also a different strategy altogether. VXX and VIX futures offer pure vega exposure, but delta-hedged straddles are just as much about gamma exposure as they are about volatility.
- Variance swaps. It’s true that the notional size and complexity of variance and volatility swaps put them out of reach for nonprofessionals, but the good news is that it doesn’t matter: On a given day, VXX and a variance swap with the same tenor will perform similarly.3 The figure below shows the cumulative sum of daily returns since 2011 of VXX and of an index published by Deutsche Bank that tracks the performance of a long position in 3-month forward 6-month variance swaps on the S&P 500 Index. Because the tenors don’t match, I’m showing 3× the daily swap returns. In the scale, –2 equates to –200%.
The point here is that if VXX is such a sub-par, retail-only product, we should expect to see a meaningful performance difference between it and professional alternatives like variance swaps. But we don’t, which isn’t a surprise because VXX tracks futures that converge to the VIX and the VIX is, by definition, just the square root of a 30-day SPX variance swap rate.
Most criticisms of volatility ETPs can be resolved with a little reflection on the nature of their underlying assets—namely, the presence of a term structure for implied volatility similar to the term structure observed in commodity futures or the yield curve in fixed income.
For instance, when the forward curve overstates the future yield for a given maturity, bond investors can profit by owning that issue and rolling down the yield curve. Should investors shun fixed-income products because their prices are sensitive to the passage of time and to changes in the yield curve? Of course not. Similarly, buyers and sellers of options and of volatility futures and ETPs should understand the factors that drive returns on those assets before drawing conclusions about their worth.
As an asset class, volatility is too expensive to be treated as a buy-and-hold investment. But as a tactically applied hedge, the returns to volatility-linked assets have a valuable role to play in smoothing out the bumps in a portfolio’s returns over time.
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1. The volatility risk premium is conventionally defined as the excess premium that option sellers demand as compensation for being exposed to the volatility of the underlying asset. It is calculated as the difference between the implied volatility of an option and the realized volatility that the underlying asset will exhibit over the life of that option.
2. As evident from the continually rising volumes in volatility futures, options, and ETPs and in the diverse mix of reported VIX positioning in CFTC Commitments of Traders.
3. Variance swaps are convex with respect to volatility, and the difference versus volatility swaps (VIX futures, VXX, etc.) matters in the tails of the return distribution. See Derman et al., “More Than You Ever Wanted to Know about Volatility Swaps.”
Good article — Couldn’t have found a better author to write the counterpoint follow up story!
Jared, I want to let you know that your book on the volatility premium was what originally prompted me to go buy some Market Data Express datasets and study the statistical relationship between implied and realized volatility. Thank you! Please consider more frequent appearances on Vol Views.
Thanks, Will! I’m actually planning to be on Volatility Views again later this month.