Is This The Right Time To Bet On Volatility ETFs?

The U.S. stocks finally managed to cross all hurdles that came in their way in the past few weeks with a sharp rise in yesterday’s trading session. Both the S&P 500 and Dow Jones industrials average posted their biggest one-day gains in more than a month. Though these gains were broad-based, the rally is unlikely to last long as a large number of concerns have already built up.

Despite the impressive one-day gain, the S&P 500 index has been trading in a tight range of around 6.5% this year and the stocks in the index are moving at an average of 18%, the narrowest in two decades. In fact, the index has been moving under 1% over the past six weeks, representing the longest stretch of calm since May 1994.

In addition, about 59% of the stocks closed above their 200-day moving averages at the end of last week, the lowest in eight months, according to Bloomberg. This suggests that the market breadth (higher number of stocks advancing versus declining) is deteriorating, signaling some pullbacks in the weeks ahead (read: Are Dividend ETFs Losing Their Multi-Year Shine?).

Further, the current economic fundamentals are signaling huge volatility and uncertainty for the coming months. This is because a raft of upbeat economic data and an accelerating job market after the first-quarter slump are raising speculation of a sooner-than-expected (as early as September) rate hike for the first time since 2006.

On the other hand, downward revision to first-quarter GDP growth, sluggish consumer spending, and falling consumer confidence for two consecutive months raises questions on the health of the economy. Yesterday, the World Bank cut its growth outlook for the U.S. from 3.2% to 2.7% for this year and from 3% to 2.8% for the next. Moreover, an aging bull market, lofty stock valuations, a strong dollar, and the Greek debt drama are weighing on investor sentiment.

Apart from these, the yields on 10-year Treasuries have been rising, reaching the highest level since September 30, 2014 at 2.478%. All these factors might keep the fear levels up. Added to the concern is the sliding transportation sector, which is alarming the broader stock market (read: Transport Leading Q1 Earnings Growth: Are ETFs Too?).

According to the century-old Dow Theory, any long-lasting rally in the Dow Jones Industrial Average should be accompanied by a rally in Dow Jones Transportation Average. It seems both indices are on the diverging path given that the former has added nearly 1% in the year-to-date timeframe against the 8.5% decline in the transportation index. This signifies that the stock market might not stay healthy going forward and see a sharp fall anytime soon.

In a woe-begotten backdrop, investors could look into volatility products that have proven themselves as short-time winners in turbulent times. They can use these products for hedging purpose to ensure safety when the stock market starts plunging.

Volatility ETFs in Focus

Volatility in the stock market is best represented by the CBOE Volatility Index (VIX), also known as fear gauge. It is constructed using the implied volatilities of a wide range of S&P 500 index options and tends to outperform when markets are falling or fear levels over the future are high.

A popular ETN option providing exposure to volatility, iPath S&P 500 VIX Short-Term Futures ETN (VXX - ETF report), sees a truly impressive volume level of about 44 million shares a day. The note has amassed $1.2 billion in AUM and charges 89 bps in fees per year. The ETN focuses on the S&P 500 VIX Short-Term Futures Index, which reflects implied volatility in the S&P 500 Index at various points along the volatility forward curve. It provides investors with exposure to a daily rolling long position in the first and second month VIX futures contracts (see: all the Volatility ETFs here).

The two products – ProShares VIX Short-Term Futures ETF (VIXY - ETF report) and VelocityShares Daily Long VIX Short-Term ETN (VIIX - ETF report) – also track the same index. VIXY has $152.7 million in AUM and sees good average daily volume of 1.3 million shares while VIIX is the unpopular of the two with just $11.1 million in its asset base and sees moderate volume of more than 81,000 shares per day. The former charges 85 bps in annual fee while the latter is costlier, charging 0.89% annually from investors. The three products lost less than 2% over the past one month.

Another product – C-Tracks on Citi Volatility Index ETN (CVOL - ETF report) – linked to the Citi Volatility Index Total Return, provides investors with direct exposure to the implied volatility of large-cap U.S. stocks. The benchmark combines a daily rolling long exposure to the third and fourth month futures contracts on the VIX with short exposure to the S&P 500 Total Return Index. The product has amassed $3.8 million in its asset base while charging 1.15% in annual fees from investors. The note trades in a moderate volume of 111,000 shares per day and lost nearly 3.5% in the trailing one month.

AccuShares Spot CBOE VIX Fund Up Class Shares (VXUP - ETF report) debuted in the volatility space last month. It provides direct access to the spot price return of the CBOE Volatility Index, or VIX and charges 95 bps in fees per year from investors. The fund trades in a small volume of about 48,000 shares a day on average and is down 0.4% since inception (read: Volatility ETF Guide: VXX vs. VXUP).

Bottom Line

These products are suitable only for short-term traders and have been terrible performers over the medium or long term. This is because most of the time, the VIX futures market trades in ‘contango’, a condition in which near-term futures are cheaper than long-term futures contracts. Since volatility ETFs and ETNs like VXX must roll from month to month in order to avoid ‘delivery’, a contango situation can eat away returns over long periods.

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