BY: HANS ALBRECHT, CIM®, FCSI®, VICE-PRESIDENT, PORTFOLIO MANAGER AND OPTIONS STRATEGIST, HORIZONS ETFS
No one knows for certain where stocks are headed, right? But what if I told you there’s an investment that has essentially been designed to go to zero over time? Would you promise not to tell anyone? Here is one of them: the iPath S&P 500® VIX Short-Term Futures ETN (“VXX”). Shhhh! Keep it down or others will try to take advantage of the trade. Actually, a lot of investors and traders know about it already, but don’t care.
Assets going into the long volatility VIX future exchange traded notes have soared in recent months. Why? Because most of the time, people need insurance. I suspect that a great deal of retail traders own VXX for a punt on a market selloff. But as we know, owning a product like this over time will result in nothing but bad news. This ETN (Exchange Traded Note) has been down 99% since its inception, and it will likely go down another 99% because they’ll reverse split it at some point, and this roll-to-oblivion will continue.
Why would someone create a product like VXX? It relates to the fact that the VIX itself is not investable. Any attempt to recreate the VIX via multi-weighted SPX options that are constantly changing is virtually impossible. The ongoing required strike-weighted adjustments and slippage from spreads would prove too difficult. So VXX, and products like it, were created to attempt to maintain a constant maturity 30-day futures position by using a blend of the front two VIX futures.
What do futures do in contango most of the time? They converge towards a lower cash price. This term-structure mechanism simply “does what it does” to maintain exposure to VIX futures, and that’s by rolling front to second futures for a loss when equity markets are relatively calm. There’s nothing untoward going on here – it’s just math. In fact, it’s ironic that great success in the product has led to its more rapid demise as large inflows have exacerbated the front curve-steepness from which it suffers: buying the second month and selling the first pushes the spread apart.
Can owning a long volatility product work? Yes it can – very well in fact. But it only works a very small percentage of the time. In panicky market scenarios, the product should react well to a significant move-up in fear levels. But in the meantime, investors should consider a product like this as similar to buying out-of-the-money puts in the S&P 500 Index. It should be seen as a short-term effort to own protection that is likely to trend downward if held for longer periods. For users hedging an underlying portfolio, that might work just fine. But does this predictable behavior of moving down represent an opportunity? Yes. You just have to understand where the edge lies. Most of the time it isn’t in holding VXX.
The views/opinions expressed herein may not necessarily be the views of Horizons ETFs Management (Canada) Inc. All comments, opinions and views expressed are of a general nature and should not be considered as advice to purchase or to sell mentioned securities. Before making any investment decision, please consult your investment advisor or advisors.