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The Fear Bubble

A mad rush of assets into short-term fear-index products distorts the VIX market.

Paul Justice, 04/04/2012

Be careful which asset classes you open up to the masses. They just might buy them.

That is advice for those ambitious exchange- traded product providers venturing into esoteric corners of the market. It is also a warning that the folks at boutique firm VelocityShares likely didn’t think they would have to consider. In late February, the fund provider’s backing bank, Credit Suisse, stopped issuing new shares of VelocityShares Daily 2X VIX Short-Term ETN TVIX, which provides leveraged exposure to the Chicago Board Options Exchange Volatility Index (VIX), otherwise known as the “fear index.” Demand was perplexingly too strong.

Many would argue that collecting too many dollars is a great problem for an asset manager to have, so the sudden closure raised questions. Why did investors run en masse to own short-term VIX futures tracking products in the first two months of 2012? And was the interest in these products really so strong as to justify shutting down the twice-leveraged note? Once the ETN essentially became a closed-end note, why did investors still demand it enough to push its price to a 15% premium over its net asset value? And, finally, why at times is there more money in short-term VIX tracking funds than there is in the actual VIX futures market?

You Never Know What Some People Will Buy
The answers to these questions may never be known, but it’s not that advisors and investors are a gullible bunch that will buy anything. They’re quite a particular group. Perhaps the digital age has simply empowered them to a point of overconfidence.

Advisors today have more analytical tools and data at their disposal than most institutions had 15 years ago. Armed with this power, advisors theoretically can execute complex yet academically sound strategies. Our research suggests that the results they’re getting are mixed. Advisors are skilled at selecting good funds, but problems still abound in getting the mix right.

Also theoretically, volatility as an asset class is an excellent diversifier for a balanced stock/bond portfolio. Its highly negative correlation to equity and credit markets provides impeccably timed zigs for market zags, and the size of its moves are often adequate to ensure that even a small position in volatility matters when it counts.

So much for theory.

In reality, properly performing a volatility asset-class investment strategy has proved to be mission impossible. In this article, we will investigate the prospects for volatility investments, address why investor demand can be rational despite some atrocious historical performance, and ultimately ponder whether or not the market can handle the demand.

Initial Cause for Concern
All too often, we witness product providers launch new funds at times when investor demand is feverishly high but the return prospects are past their prime—classic performance chasing. The first volatility ETFs may take top prize for most poorly timed launch from a performance perspective: Their inceptions were in January 2009, less than three months after the VIX peaked at 89.5.

While it is well known that the correlation of returns to previously uncorrelated assets goes to one during a deleveraging crisis, such is not the case with volatility. In fact, the timing of the jumps in volatility investments is the only positive aspect of this abstract asset class. In most investments, we seek positive risk-adjusted returns for the asset class independent of the rest of the portfolio. With volatility investments, we fully expect to lose small sums of money during most periods with the hope that positive jumps will be large enough to ease the pain caused by disaster in the rest of the portfolio.

This is a form of portfolio insurance not unlike a policy taken out on a real asset, such as a home or car. The small monthly losses an investor experiences from rolling into new VIX futures contracts serves as their premium payment, and payout only comes when something bad happens. Overall, investors wouldn’t expect to make a positive return on insurance; they simply hope it will mitigate substantially any losses incurred.

Unfortunately for iPath (the purveyor of the first volatility funds), the firm waited until the VIX index had jumped higher than it ever had before launching its funds. Purchasers of these insurance products were essentially paying outrageous premiums because they bought after the disaster started, not when all was calm. This certainly had an impact on their return results. Just take a look at the return chart for the first and largest short- term VIX exchange-traded product, iPath S&P 500 Short-Term Futures ETN VXX, to see some atrocious results (Exhibit 1). I think we can agree that losing 62% annualized, or more than 95% of its original value in just over three years, is more than uninspiring. It’s downright scary.


A Rebalancing Plan of Attack
If the products had launched just six months sooner, the track record would not likely appear as poor. Furthermore, an investigation of a hypothetical reconstruction on these products illustrated that they could improve the risk-adjusted results of a 60/40 stock/bond portfolio quite handsomely despite their abysmal returns. The trick is knowing how to execute the strategy and having the ability to rebalance the portfolio at least monthly.

This prompted my former colleague Bradley Kay to write an instructional article for these invest- ment strategies titled “Quant Corner: Is Volatility a Smart Investment?” (Morningstar Alternative Investments Observer, First Quarter 2011). Keep in mind, the article was published after volatility products had already posted abysmal returns, but Kay made a conditional case for the usage of volatility products by sophisticated investors.

Kay found that if an investor added a 10% position to S&P 500 VIX Short-Term Futures to a typical 60/40 portfolio and rebalanced monthly (thus reducing equity to 54% of the portfolio and bonds to 36%), the Sharpe ratio of the portfolio fell to 0.10 from 0.28. Clearly, this was not an efficient hedge. If an investor used midterm futures instead, however, the results changed dramatically. Adding a 20% stake to S&P 500 VIX Mid-Term Futures to the base 60/40 portfolio (making equities 48% and bonds 32% of the portfolio) not only reduced the volatility of the portfolio, but it also increased returns. The Sharpe ratio jumped to 0.65 from 0.28. A year later, the data tell the same story (Exhibit 2).


Adding a stake of short-term VIX futures to the 60/40 portfolio substantially reduced the standard deviation and the negative skewness (higher downside risk) of the portfolio, but it also lowered the absolute size of returns while still possessing some of the high kurtosis (fat tails) of traditional equity-heavy portfolios. However, adding midterm VIX futures to the portfolio instead resulted in higher returns and a similar standard deviation as the short-term VIX portfolio, but with double the Sharpe ratio and reduced kurtosis. (Exhibit 3 displays recent performance of the portfolios.)


This evidence shows us that a volatility investment can work—if you choose the right one at the right time. Based on historical evidence, now is the right time. Investors should initiate a VIX position when it is below its long-term average of around 21. Thus, I can understand why we’ve seen increased interest in volatility products. But if all the evidence points to midterm futures being the better choice, why is there overwhelming interest in the short-term futures?

Cornering the Uncertainty Market
Dave Nadig of IndexUniverse made an observation recently: The total notional exposure of ETNs and ETFs in short-term VIX products actually exceeded the notional exposure of the futures markets themselves. In other words, the short-term volatility market was overwhelmingly dominated by passive investments made through ETFs and ETNs.

Perhaps the oddest element of this domination of the futures market is that, in the grand scheme of things, there isn’t a ton of money in volatility products. At just $3.7 billion in 30 different volatility-related products in the United States, it’s shocking that ETFs are that large a portion of the market. The volatility market simply was not massive enough to open it up to the masses.

Protect Yourself
In physical asset markets, regulators would step in to prevent futures-market manipulation of underlying spot asset prices, but here’s the rub: There is no such thing as a spot market for volatility. It’s an abstract concept, an amalgamation of components of option prices.

There are no end consumers to disrupt, so the folks at the Commodities Futures Exchange Commission and the SEC really have no reason to impose position limits. What we are witnessing is a lopsided game where insurance sellers are reaping outsized premiums for the coverage they are selling. It’s materializing in the form of a gigantic negative roll yield more commonly known as contango. The victims are the owners of short-term volatility products.

People have become so focused on avoiding the next speculative bubble that they are running from risky assets at inopportune times. This is a form of recency bias, where we remember recent events more vividly than those in the distant past. Logic tells us that we should be as willing, if not more so, to take risks after something bad happens, but emotions prevent us from doing so.

Risk aversion is not only driving simple asset-allocation decisions, it is also driving investors into hedges that they know little about. It may sound odd, but we appear to be witnessing a speculative rush away from rational risks. We are in a fear bubble.

Investors are afraid to let their traditional asset-class mix act as both the risk and return modulators. What people using volatility products as hedges are ignoring is the sky-high cost of insurance. The futures curve for volatility is telling us that, unless the apocalypse really is coming, it will be nearly impossible to make money with these products today. The futures curve is in such an ugly state of contango that, if the volatility index simply stays where it is today, investors can expect to lose nearly 10% every single month. Investors actually should be fearing fear itself.

My advice to investors that are clinging to the experience of 2008 and feel an insatiable urge to protect themselves by using these complex products is to let it go. However, if you must venture into volatility, stick with the mid-term futures for now. The only way I can see a short-term VIX strategy working is if I am the one selling insurance, and most investors don’t have a bankroll large enough to counter the impact of being wrong.

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