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We're Not Buying Fear Quite Yet

Volatility can offer attractive portfolio insurance, but not at recent prices.

Bradley Kay, 02/01/2010

What a difference a few days can make. The VIX index, or so-called "Fear Index," was sitting near 17 on Monday of last week, a new low since the collapse of Lehman Brothers back in September 2008. Investors seemed more sanguine about the stock market's prospects than they have in months, and it looked like insurance against another big crash might finally be cheap again. But by midweek, the market was staggering from several surprises: new regulations for big U.S. banks, credit tightening in China, and increased sovereign risk through the Eurozone. The VIX surged 55% from its Monday close, and the window for buying cheap insurance on the market shut. But did the opportunity ever exist in the first place?

The Fear Index
Let's take a step back to explain what exactly the VIX index is. Briefly, the VIX index is a crude measure of the uncertainty that traders feel about the short-term prospects of the market. It looks at the prices of option contracts on the S&P 500, which will tend to be higher when uncertainty is greater, and distills the information contained in all the call option and put option prices into a single estimate of the standard deviation of returns for the S&P 500 Index over the next month. This calculation method explains why the VIX is also called a "volatility" index, in reference to the options terminology for the expected standard deviation of an asset price.

Volatility has a couple interesting attributes that make it a unique addition to any balanced portfolio. First, it is one of the only asset classes to rise whenever stocks fall (hence the VIX index's nickname of The Fear Index). Second, it can rise wildly out of proportion to the fall in stocks. Just last week the VIX rose 55% as the S&P 500 fell 4% in four days. In 2008, the VIX rose a whopping 500% from May lows around 16 to a high close of 80 on October 27, while the S&P 500 fell only 37% over the same time period. Volatility can also experience sickeningly sharp declines as the market recovers, which makes it a poor asset to always hold in the portfolio. But there is no better insurance hedge out there when the market seems too comfortable and the VIX is hovering below its long-term average of 20.

But Was the Insurance Really There?
So if the VIX fell so low just a week ago, and it provides such an excellent insurance hedge against stock price declines, why weren't we screaming and yelling for everyone to buy it? Unfortunately, the VIX index is almost entirely impossible to purchase directly. It depends on the price of a complex and constantly changing weighted portfolio of options, which we mere mortals could never replicate for a manageable cost. Instead, institutional investors and now ETF investors can purchase futures contracts that eventually settle in cash for the spot price of the VIX index at expiry. These futures contracts on the VIX index usually do a good job of following the spot index, with only minor losses each year as each futures contract expires and investors roll into the next one. Unfortunately, throughout 2009 and into this year, the prospects of a VIX futures investment looked extremely shabby thanks to a familiar foe for anyone who invested in commodity futures this past year: contango.

Because investors seeking a portfolio hedge cannot buy the VIX directly, these futures contracts bear the full brunt of panic purchases from investors seeking insurance. In 2009 and continuing into the first trading days of 2010, that kept the prices of near-month VIX futures as much as 10%-20% above the spot price, causing vicious losses as one contract expired and positions rolled in the more expensive future further out the curve. This also deadened the price appreciation that a VIX investor could expect when volatility spiked. When the VIX rose 55% last week from Monday's close to Friday, iPath S&P 500 VIX Short-Term Futures ETN VXX rose only 15%. From that ETN's inception on Feb. 2, 2009, to the end of the year, the spot VIX index fell 52% while the futures-tracking ETN lost 67%. Those may sound almost equally bad, but think about it this way: You would have finished the year with half of your original investment in the spot VIX, but only a third of your original investment in the rolling futures contracts. Now think about how much harder it is to triple your investment value than to double it (not to mention how hard it is to do either one).

So When Is Volatility Worth Buying?
Thus far we're feeling pretty good about our decision to not buy portfolio insurance through the VIX futures ETNs. But really, we just sat on the sidelines for the past year. The real proof of our ability to use this portfolio hedge comes when we can identify the time to start buying.PAGEBREAK

First you need to know how volatility has behaved in the past. Historically, it has bounced around considerably but tends to return to a long-term average of around 20. Frequent lulls can take it down into the teens, with occasional spikes that bring the VIX up into the 30s or even 40s during shorter panics such as the 1997 Asian currency crisis, the 1998 Russian debt default, the 2001 World Trade Center attacks, and the 2008 emergency sale of Bear Stearns. Thus, it makes the most sense to buy volatility as portfolio insurance when it is under 20, or else the investment will lose money from a calm market as likely as it will gain from a new panic.

How you buy into volatility matters just as much as the price. Because buying VXX is equivalent to buying futures contracts that frequently trade in contango, holding VXX during a period of peaceful markets is going to slowly lose money even if the VIX holds steady. While panics that cause the VIX to spike do seem to happen every few years, that could be a very long wait with losses on a volatility position adding up. Instead, you should buy in slowly over time as VIX futures become cheap enough.

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