Volatility as an asset class

Thanks to the exchange-traded fund industry, hedging stock market volatility — or betting on it — has never been easier

Thanks to the exchange-traded fund industry, hedging stock market volatility — or betting on it — has never been easier. However, doing it well enough to make money can be a much different story.

Over the past few years, the financial services industry has rolled out a growing list of innovative exchange-traded products designed to give investors exposure to market volatility as an asset class.

Rising volatility, as measured by the price of put and call options on the S&P 500, generally signals investor fear and a bearish run for equities, which can make some volatility-based ETFs ideal tools for hedging portfolio risk.

Of course, timing is everything.

“If you had a crystal ball, these kinds of products would be great to own, but the problem is [that] getting in and out at the right time is hard to do,” said Christian Magoon, an independent ETF industry consultant and chief executive of Magoon Capital LLC.

For example, if one could have anticipated the unfolding of the European debt crisis last spring, it would have been a good time to own something like the iPath S&P 500 VIX Short-Term Futures ETN Ticker:(VXX).

That particular exchange-traded note, offered by Barclays Bank PLC, is designed to track the performance of the S&P 500 VIX Short-Term Futures Total Return Index.

Between April 20 and June 7 of last year, when fears of European defaults drove the S&P 500 down 13%, the volatility-linked iPath VXX shot up 76.7%.

But even such a stark example of an equity market hedge doesn’t necessarily represent a ringing endorsement for jumping headlong into the latest volatility-linked ETF.

BRIEFLY HELD

“These kinds of products are designed for traders and hedgers who are seeking protection when market volatility goes up, but they might hold it for a few hours or a day,” said John Spence, web editor at Global Trends Investments.

A few fear-related spikes not withstanding, the longer-term record of the $1.3 billion VXX does not bode well for buy-and-hold investors.

From its Jan. 30, 2009, launch through July 14 of this year, the VXX declined by 95%, which compares with a 60% gain by the S&P 500 over the same period.

“The [iPath VXX] was introduced at the worst possible time, because market volatility has gone down steadily ever since it was launched at right near the stock market’s bottom,”Mr. Spence said.

In early July 2010, Barclays had to shut down its iPath Long Enhanced S&P 500 VIX Mid-Term Futures ETN Ticker:(VZZ) because of its shrinking share price.

Launched in November 2009, the product was offering levered performance of the volatility index, which contributed to its demise.

Part of what makes investing in volatility-linked ETFs so tricky is the multiple moving parts inside the products.

For starters, the underlying investments are really futures contracts that are being constantly rolled over in order to keep the maturities within a certain range.

This commonly results in bearing the cost of contango (a condition in which a futures contract is trading above the expected spot price at contract maturity) when a portfolio is required to sell lower-priced maturing contracts while buying higher-priced replacement contracts.

Investors should also know the difference between exchange-traded funds and exchange-traded notes in this space.

ETFS VERSUS ETNS

The iPath VXX is an example of an exchange-traded note, which means it is not necessarily investing in the underlying futures contracts or index it is designed to replicate.

Unlike ETFs, ETNs are debt obligations, which means investors are taking on risk related to the creditworthiness of the issuer.

The ProShares VIX Short-Term Futures ETF Ticker:(VIXY), which was launched in January by ProFunds Group, is an ETF version of the iPath VXX exchange-traded note.

The evolution of the volatility ETF niche also has seen iterations that allow investors to hedge or leverage exposure to market volatility.

The VelocityShares Daily Inverse VIX Short Term ETN Ticker:(XIV), for example, is designed to replicate the inverse of the daily performance of the S&P 500 VIX Short Term Futures Index.

As of Aug. 2, this exchange-traded note, launched in November by VelocityShares LLC, was up 30% from the start of the year, reflecting the steady decline in market volatility, or investor fear.

Then there is the VelocityShares Daily 2X Short Term ETN Ticker:(TVIX), which is leveraged to provide twice the daily performance of the market’s volatility.

This strategy, which also was launched in November, has declined by 65.8% from Jan. 1 to Aug. 2.

Harry Rady, who manages $270 million as chief executive of Rady Asset Management LLC, uses these kinds of volatility products to enhance the performance of his long/short equity portfolio.

With the Chicago Board Options Exchange Market Volatility Index, or VIX, currently below 20, Mr. Rady sees more upside potential than downside risk for volatility.

“Volatility is as low as it has been since July 2007, so I would argue that investors are complacent and protection is cheap,” he said. “My simplistic view is that volatility could go down another 10%, but it could also double or triple if we get another disaster, and that’s an asymmetric risk-reward ratio.”

‘NOT A FREE LUNCH’

Mr. Rady admits, however, that “this is not a free lunch, because if the stock market continues to move upwards, and nothing negative happens, you’re going to lose money” on the VIX trade.

Just as Mr. Rady will add exposure to a volatility-linked strategy when volatility is low, he will buy an inverse strategy such as the VelocityShares ETN when volatility spikes up.

“You play the XIV when you get a spike in volatility, because as that volatility declines, that fund will go up,” he said. “This is a prudent, wise and inexpensive way to use volatility in a portfolio. It’s just a question of timing.”

At this point, the volatility market is evolving at a steady pace, and that bodes well for volatility as a legitimate asset class, according to Mr. Magoon.

“In my opinion, volatility already is an asset class, but VIX products are probably not the best way to play it,” he said. “It would probably be better to just buy gold or certain Treasuries that tend to attract more assets as volatility rises.”

Mr. Magoon believes that the financial services industry will end up developing an investment-strategy-based volatility product that doesn’t depend on futures contracts for exposure.

Mr. Magoon is expecting the ETF market to develop innovative ways for investors to gain exposure to volatility in the way that the energy market has futures-linked products and equity-based products tied to the same commodity.

“I’m sure there’s somebody out there who is already looking at equities, or sectors or industries, that have the best correlation to volatility,” he said.

Email Jeff Benjamin at [email protected]