Skip to Content
ETFs

VIX-Linked Investments Are a Risky Bet Over the Long Haul

Recent returns on VIX-tracking exchange-traded products may be enticing, but their risks are substantial.

While most investors focus on stock market performance, it is also possible to bet on expected market risk using instruments tied to the CBOE Volatility Index, or VIX. Long VIX positions are essentially a bet on higher market risk, which often coincides with poor market returns. Conversely, being short the VIX conveys a view of lower expected market risk and higher market returns.

In recent years, it has paid off to bet against market risk. A dollar invested in December 2010 in a VIX exchange-traded product that bet against market volatility would be worth $9.38 as of this writing. This phenomenal return can be attributed to the stock market climbing steadily higher with lower volatility than expected.

Realized volatility is often lower than the volatility assumptions priced into the VIX because that index is a form of insurance against spikes in market risk. And no one would be willing to write that insurance without being compensated for that risk. This expected compensation is known as the volatility premium.

In June, I explored how investors can capture the volatility risk premium with equity index option-writing funds in an article titled "Systematically Harvesting the Volatility Premium." Like systematic equity index option-writing funds, inverse VIX-tracking ETPs profit from the volatility premium, but VIX ETPs are much riskier and their returns are much more correlated to equity market returns because they track the VIX futures curve and reset their exposure daily.

VIX-tracking ETPs do not invest directly in spot VIX; they use a combination of VIX futures contracts to gain exposure. The VIX is a measuring stick of stocks' expected volatility during the next 30 days. The VIX formula calculates the S&P 500's expected 30-day volatility by averaging the weighted market prices of S&P 500 put and call options across a wide range of strike prices.[1] Individual investors could not easily trade the VIX until CBOE launched VIX futures in March 2004, and Barclays launched the first VIX ETPs, iPath S&P 500 VIX ST Futures ETN VXX and iPath S&P 500 VIX MT Futures ETN VXZ, in January 2009. As of mid-September 2017, there are 22 U.S. VIX-tracking ETPs with $5.2 billion in assets. Not only do these funds target VIX futures with different maturities, but they also offer leveraged (magnified) and inverse VIX futures returns. The top 10 VIX-tracking ETPs, as ranked by assets under management, are shown in the table below.

Fund sponsors initially offered long-only VIX ETPs as a means to hedge equity risk because S&P 500 drawdowns have historically coincided with greater volatility. From Nov. 1, 2006, through Sept. 15, 2017, the daily VIX and S&P 500 price returns have exhibited negative 0.73 correlation. Indeed, a long VIX ETP position can serve as a useful hedge for a sharp S&P 500 drawdown. For instance, the S&P 500 fell 3.6% after the Brexit vote on June 24, 2016 and VXX, which targets the one-month VIX futures contract, posted a gain of 23.7% on the same day. But holding a long position in a short-term VIX ETP has been a losing bet over the long haul. From Nov. 1, 2006, through Sept. 15, 2017, VXX has posted an annualized return of negative 70.3%. This is largely attributable to the VIX futures term structure and VIX ETPs' daily reset.

To maintain a long position in VIX futures, a fund has to sell contracts as they approach expiration to purchase longer-dated contracts. When the price of an expiring contract is lower than the longer-dated one, it hurts the investor's returns, even if there is no change in the spot market. This condition is known as contango. The term structure of VIX futures has been in contango for 71% of the trading days from Nov. 1, 2006, through Sept. 15, 2017.

Equity hedging costs may help explain why the VIX futures curve is usually in contango. At its core, the VIX is a formula that calculates expected volatility using S&P 500 option prices, so the volatility premium contributes to its state of contango. The volatility premium is the difference between an asset's implied (expected) volatility and its realized (actual) volatility in a given period. Each VIX futures contract represents the implied 30-day volatility as of that future contract's expiration date. Pricing forward-looking volatility in the future is difficult, and investors have historically overpaid to hedge risk. the graph below shows the one-month implied volatility (as measured by VIX) minus the S&P 500's one-month realized volatility from Dec. 1, 2006, through Sept. 15, 2017. On average, implied volatility has measured 3.4 percentage points higher than realized volatility during this time period.

VIX ETPs' daily reset compounds the problem. VXX strives to deliver the daily return from a constant-maturity one-month VIX futures strategy by holding long positions in the next-nearby and second-nearby VIX futures contracts in weightings that create an average one-month maturity. As each day passes, VXX sells a portion of shorter-dated VIX futures to fund the purchase of the second-nearby VIX futures contract to maintain its one-month maturity. Because the VIX futures curve is generally in contango, VXX usually buys the higher-priced second-nearby future and sells the less-expensive next-nearby future every day. This has translated into large losses.

If long VIX ETPs consistently pay the volatility premium and suffer from negative roll yield, then betting against volatility with inverse VIX ETPs might pay off. But inverse VIX futures strategies are not for the faint of heart and carry considerable risks.

What Could Go Wrong? First, inverse short-term VIX ETPs don't offer diversification benefits and effectively provide leveraged long S&P 500 exposure. VelocityShares Daily Inverse VIX Short-Term ETN XIV offers inverse one-month constant-maturity exposure to VIX futures. VelocityShares launched XIV in late November 2010. From Dec. 1, 2010, through Sept. 15, 2017, its daily returns have measured a 0.82 correlation and 3.6 beta with the S&P 500's price-only returns. Although XIV itself is not leveraged, with a beta of 3.6, it essentially provides magnified exposure to the risks embedded in the S&P 500.

Second, volatility spikes can wipe out several months' worth of the returns. Inverse short-term ETPs have experienced wild swings and extreme drawdowns. From its inception in December 2010 through mid-September 2017, XIV's annualized volatility measured 64%. The fund has experienced 144 daily drawdowns of greater than 5% and 35 greater than 10%. Its largest drawdown measured 26.8% and occurred after the Brexit referendum on June 24, 2016. This fund also experienced a 47.9% drawdown during the month of August 2015. These are tough losses for any investor to endure, and given its correlation with U.S. equity markets, it's unlikely that many investors held this position through thick and thin.

Third, VIX-linked strategies create operational headaches and are expensive. Most are structured as either an exchange-traded note or an investment trust. ETNs add credit risk to the mix because they are uncollateralized debt securities that offer the return of an underlying index in exchange for a fixed fee. If the ETN issuer can't honor those payments, investors lose. VIX-linked strategies that use the investment trust structure are classified as partnerships and subject holders to K-1 tax filings. These generally result in 60% long-term/40% short-term gains/losses on the investor's tax return. Regardless of structure, these funds' median net expense ratio measured 1.1 percentage points as of mid-September 2017.

Recent returns on VIX-linked ETPs may be enticing, but their risks are substantial. VIX ETPs target VIX futures rather than spot VIX, so these ETPs are not are a directional bet on the current VIX level, but rather whether future volatility will be higher than investors expect. It is probably more prudent to adopt a more conservative asset allocation than use long VIX ETPs to hedge against market drawdowns. The high expense ratio and negative roll yield associated with long VIX positions have cost investors dearly over the long run. For those interested in capitalizing on inverse VIX ETPs, understand that this is essentially a leveraged S&P 500 bet and inverse VIX ETPs will not offer diversification benefits to equity holdings. All told, VIX-tracking ETPs are an interesting wrinkle in the ETP landscape, but they probably aren't useful as a long-term investment.

[1] The CBOE Volatility Index – VIX White Paper. https://www.cboe.com/micro/vix/vixwhite.pdf.

Disclosure: Morningstar, Inc. licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please click

for a list of investable products that track or have tracked a Morningstar index. Neither Morningstar, Inc. nor its investment management division markets,

or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.

More on this Topic

Sponsor Center