Matt Hougan at Index Universe (via Abnormal Returns) offers a good critique of investments that are designed to give investors a bet on volatility.
At first glance, volatility looks like a cheap bet right now. The iPath S&P 500 VIX Short-Term Futures exchange traded note has done nothing but fall (with a few brief spikes) since it was introduced at the height of the financial crisis, because fear and volatility - as reflected in the VIX volatility index - have subsided remarkably fast over this period.
The ETN units fell to just $17.84 (U.S.) last week, from a high of $119.38 in February, 2009, when the S&P 500 was just days away from hitting a 12-year low. But these units are supposed to provide a bearish hedge against the market: When things go wrong for the S&P 500 and investors get scared, the VIX volatility index generally rises and the ETN goes along for the ride.
On Tuesday, during the global market rout, the iPath VXX ETN jumped 9.9 per cent. If you think stock markets are due for another nasty bout of turbulence, this isn't a bad way to put those bearish thoughts into action.
But Mr. Hougan notes that there are a few big problems with this investment strategy. First, the ETN tracks VIX futures rather than the VIX itself. According to Mr. Hougan, VIX futures already imply some volatility ahead, which means that some degree of bearishness is already factored into the investment.
The note is also relatively expensive, with a management fee of 0.89 per cent.
And lastly, he pointed out that ETNs are debt notes, which leave investors exposed to potential default by the issuer.
"The idea that you're voluntarily taking this risk on an instrument only designed to make you money when volatility is going through the roof seems odd," he said. "I love the idea of investing in volatility; VIX futures just aren't a great way to skin this cat."