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Market protection

Hedging with volatility ETNs Add to ...

Vikash Jain, founder of wealth-management firm archerETF Portfolio Management in Toronto, was worried that his clients' portfolios might take too much of a beating as the financial crisis in Europe deepened.

So, he decided to do some hedging. He sold down a portion of his client's equity holdings and transferred the proceeds into an exchange-traded note (ETN), the iPath S&P 500 VIX Short-Term Futures Note, trading in New York under the symbol VXX.

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The VXX is seen as a hedging tool by some investors because it is linked to the Volatility Index (VIX), which rises when the market tumbles. This rise occurs because VIX tracks options on the S&P 500 and their prices are bid upward when investors increasingly seek to use options to hedge against volatility and portfolio losses.

Investors who bought VXX recently have been well rewarded. It gained 40 per cent during May, compared to a loss of 8.5 per cent in the S&P 500. But VXX is not a tool for the inexperienced. There are at least four things to be aware of.

First, stock-market volatility follows a rather distinctive pattern. Occasional periods of investor panic give rise to a strong desire to hedge with options, and a consequent upward spike in the VIX. This is typically followed by a prolonged and gradual decline in the VIX as investors' fears ebb and hedging with options dwindles.

Related contentVIX ETN body chart

Recent history is illustrative. In the depths of the last bear market, VIX soared to an all-time high of 80. As the market recovered after March, 2009, it declined steadily to a trough just above 15 in April, 2010. Now it is back up to 40 on euro zone debt concerns.

Thus, VXX is not well suited for long-term bets. Its tendency will be to follow the VIX down over extended periods as bull markets progress. When periods of appreciation occur, they will be sharp and short lived, confined to downdrafts in the stock market. So, some nimbleness is required when buying and selling VXX.

Second, VXX can have a significant negative tracking error. That's because VXX is based on the first- and second-month futures contracts on the VIX, and if they are in contango (contracts further from expiration have higher prices), a phenomenon called "negative roll yield" arises.

It causes VXX to trend below the VIX as follows. When futures contracts held by the ETN expire, they need to be rolled into the next available contracts; when the latter have higher prices (as exists under contango), the roll will give rise to a loss that pulls down the ETN even if VIX was unchanged over the time period.



Hold tight for a wild ride, breathe deeply and just keep chanting, 'The only constant is change, and change is the only constant….' Vikash Jain, archerETF


Again, history is illustrative. Over the past year, the VIX was essentially unchanged -- with its recent spike recouping the decline recorded during the market rally. The VXX rallied sharply in May, but it is still down by over 50 per cent during the same yearly period.

The cousin to VXX, the iPath S&P 500 VIX Mid-Term Futures Note (symbol VXZ) requires less adroitness in timing trades. It uses VIX futures with four- to seven-month maturities (which are less impacted by negative roll). Over the past year, VXZ has come back to breakeven like the VIX, and with less volatility. The trade-off, though, is smaller upward spikes during market sell-offs, like in May.

Third, like other ETNs, both VXX and VXZ are debt instruments of the issuer, in this case Barclays Bank PLC. So, they are subject to credit risk: if the issuer goes under, so does the ETN. This was a serious concern during the credit crunch of 2008, but has abated since then.

Fourth, users of VXX may be able to capture hefty gains quickly but they might want to fasten their seat belts. "About a quarter of recent daily price moves are more than plus or minus five per cent," observes Mr. Jain. "Hold tight for a wild ride, breathe deeply and just keep chanting, 'The only constant is change, and change is the only constant….' "

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