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Is the VIX a Value Play? Unfortunately, No

March 27, 2012 | About:
The CBOE Volatility Index, or VIX, is a measure of the market’s expectation of volatility (one standard deviation of returns) in the S&P 500 over the next thirty days (as evidenced by the implied volatility of options the S&P 500). It turns out to be a good measure of future volatility, as the following chart indicates (h/t EconomPicData):

vixspy.pngVIX vs. Forward SPY Return, Source: EconomPicData

There are several exchange traded products (ETPs) which track the VIX, allowing investors to take positions based on their view of future volatility. Some focus on short maturities of the VIX, while others focus on longer maturities. Some use leverage and some are inverse products. The following handy chart shows the range of ETPs:

VIXETPfieldguide022112.pngVIX ETP Field Guide Feb 2012 - VixAndMore

Two of the popular levered ETPs are the ProShares Ultra VIX Short Term Futures ETF (NYSE: UVXY) and the VelocityShares Daily 2x VIX Short-Term ETN (NYSE: TVIX). TVIX recently made headlines when, just a month after its sponsor announced it would suspend creating new notes, the ETN traded at a 80-90% premium to NAV only to plummet in recent days (some believe this is due to information leakage relating to its sponsor’s announcement that it would begin creating new notes again, in part to close the premium).

UVXY followed suit with a similar (though lesser) decline, despite the fact that UVXY’s premium to NAV never exceeded 3%. This hints that something else is going on than a mere correction of an overpriced security (TVIX). One explanation (and I am sure there are others) is that the underlying asset these these ETPs track, the VIX, has been in free fall. In fact, as we see here, the VIX has fallen to its lowest level since mid-2007 (h/t Mark Perry):

vix.jpgVIX, January 2007 - March 2012 - Source: Mark Perry

As Perry points out, the last time the VIX was this low, the Great Recession was still six months away. At its current level of 14.26, the VIX is implying that one standard deviation of market performance for the next thirty days is +/- 4.12% (details on this simple calculation here). Twenty days ago, the market was implying +/- 6.14%, which is a significantly greater dispersion of possible returns. Simply put, the market is more confident in its assessment of the future.

When the market becomes more confident (by this measure, more confident than it has been since mid-2007), this is often a sign that investors should take pause and consider whether equities (the S&P 500) are “priced for perfection” or otherwise not fully considering the downside. There are certainly no shortage of reasons to be worried about problems abroad leading to issues for American companies, and many rightfully question whether we are in for a repeat of 2011, when a strong start gave way to continued weakness and massive (historically high) volatility.

Given the level of the VIX, one might wonder whether buying at a 5.5 year low could be a value play, especially when the market seems to be overconfident in the face of major risks. The hurdle appears to be lower today than at any other time over the last half decade, so could this be a “heads I win big, tails I just lose a bit” scenario?

Unfortunately, no.

Investing in a VIX ETP today carries with it significant risks which are not immediately obvious. To understand these risks, you need to understand how VIX ETPs work. First, recognize that futures have definite expiry dates, so to maintain the same maturity, ETPs have to roll into newer assets by selling aged futures in favour of new, younger maturities (think Hugh Hefner).

Second and this is probably an obvious point but it is really important: ETPs do not track the spot price of the VIX, but rather the price of futures contracts on the VIX. So we don’t care about the current price, however low it may be, but rather we care about what the futures prices are. When you plot the prices of different maturities of these futures, you get a term structure.

The VIX futures term structure is currently extremely steep (earlier this month, it was the third steepest it has ever been). A steep term structure means that the futures prices are more expensive than the spot price. So when these ETPs purchase futures contracts they are buying them at a level higher than what the current spot price is. This scenario is called contango, and it means that as time progresses, the price of that futures contract will decline as it converges on the spot price.

The difference between the spot price and the futures price when you buy it is essentially a premium whereby you are betting that the spot price will increase to the futures price rather than the futures price declining to the spot price. The bigger the difference, the greater the premium and the more the spot price has to increase for you to chalk up a gain.

So over time, the ETP buys a high priced futures contract on the VIX, and then later sells it to purchase another maturity. This is the process of “rolling forward” to maintain a relatively constant maturity range. In contango, this costs money (a negative roll yield), because in contango the purchase of new futures occurs at higher prices than the sale of the old, aged futures contracts.

If you didn’t catch all of that, the key is this: the steeper the term structure, the more expensive the cost of maintaining the position (i.e. the greater the negative roll yield). As I mentioned above, the VIX term structure is excessively high. By my calculations (using data on the VIX term structure here), the negative roll yield is currently 14.5% (not annualized) two months out (at the start of March, it was this expensive one month out but it has since moderated on the shorter maturity only). This amounts to a bet on a very large increase in volatility in the short run. Anything less means you are left with an unprofitable investment.

Speaking of unprofitable investments, I’ve only covered one “hidden” cost that raises the hurdle for a profitable VIX investment but there are a lot of other expenses and costs associated with VIX ETPs, especially those that use leverage. So while the VIX might be at the lowest level in recent memory, it hardly translates into an obvious value opportunity. Even viewing the VIX not as an investment but as portfolio insurance means you are paying some of the highest rates in history for that insurance. How certain are you of your forecast?

In my research, I did come across this idea of Dynamic VIX ETPs which are designed to minimize the negative roll yield, but they appear to be unproven and I am still trying to wrap my head around them so I will leave that for more capable VIXens (ok, I made up that term. No one else uses it, or should use it.).

For those interested in reading more about the VIX, you will find more than your fill over at the always excellent VixAndMore.

Author Disclosure: None

About the author:

Frank Voisin
Frank is an entrepreneur who owned four restaurants by the time he was twenty. He sold his businesses and returned to school, completing a concurrent Law / MBA degree. At the same time, he successfully completed all three levels of the CFA exams. He now invests full time with a focus on value investing. Frank Voisin writes about value investing topics at http://www.frankvoisin.com.

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