S&P Dow Jones research points to potential gains for VIX ETFs

Aug 22nd, 2016 | By | Category: Alternatives / Multi-Asset

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A note from S&P Dow Jones Indices (S&P DJI) suggests that the CBOE Volatility Index (VIX) could be poised to increase sharply from this week, citing seasonal trends as well as expectations derived from the VIX futures curve.

S&P Dow Jones research points to potential gains in VIX ETPs

The VIX “fear index” could be poised to rise, according to S&P Dow Jones Indices.

For investors looking to protect their portfolios from rising volatility, VIX-linked exchange-traded products, such as the Boost S&P 500 VIX Short-Term Futures 2.25x Leverage Daily ETP (VIXL), could provide an effective hedge.

Similarly, for traders with a shorter time horizon, the current calm could present an opportunity to take out a speculative long position in such products, which would profit from an increase in volatility.

The VIX index, also known as the ‘fear index’, represents the implied volatility of US equities, derived from option pricing on the S&P 500. It is a measure of the market’s expectation of stock market volatility over the next 30-day period.

S&P DJI says that the VIX has been subdued throughout August and, as of Thursday 18 August 2016, remains close to its lowest level in two years.

The index provider notes that conditions have been conducive to keeping VIX low in recent weeks: there have been no significant shocks to the global economic system, oil price volatility is currently at levels half of those seen in February, currency volatility has stabilised to historical norms following the initial turmoil caused by the UK’s decision to leave the European Union, and policy announcements from the US Federal Reserve’s Open Market Committee are broadly in line with market expectations.

But this grace period may soon be over, cautions S&P DJI. According to data, August is traditionally a quiet month for US equities. This has been attributed to an intentional deferral of corporate announcements, elections and product launches, at a time when a significant number of traders and investors go on holiday. The result is that during September and throughout October, the market attempts to process an unusually large amount of information as deferred events as well as current news hits investors’ radars at the same time.

This seasonal effect has been encapsulated by S&P DJI in the graph below, which plots the ratio of the average level of VIX in comparison to its one-year trailing average at each point in the year, between 1991 and 2016. Both the average ratio (in red) and the 25% to 75% percentile range of ratio values (grey shaded area) indicate a clear uptick in volatility compared to its one year trailing average, commencing roughly from week 35 in the year. S&P DJI notes that this year the VIX is particularly low, at 30% below its 12-month trailing average.

S&P Dow Jones research points to potential gains in VIX ETPs

S&P DJI chart. Sources: S&P DJI and CBOE

Tim Edwards, Senior Director of Index Investment Strategy, wrote: “August is traditionally a quiet month… in September and throughout October, the world returns to business. The 35th week of the year showed, on average, the biggest rise in volatility. We are presently approaching the end of the 34th week of 2016, investors might wish to bear this history in mind.”

S&P DJI points out the VIX futures curve is unusually steep, indicating that traders are anticipating an imminent rise in the index. As of 17 August 2016, the front future price represented a 21% increase in VIX from its current level – a spread within the highest 1% of all such observations historically.

Volatility ETPs, such as the aforementioned Boost product, are designed exactly for these sorts of scenarios and offer an accessible solution for investors anxious about rises in volatility or for traders looking to speculate. The Boost ETP is listed on the LSE, Borsa Italiana and Xetra and provides 2.25 times the performance of a daily rolling long position in first and second month VIX futures contracts. This means that if the S&P 500 VIX Short-Term Futures Index ER, its underlying reference, rises by 1% over a day, then the ETP will rise by 2.25%, excluding fees. With annual fees of 0.99%, the ETP is pricey but nonetheless provides investors with a powerful tool.

An alternative to the Boost ETP is the Lyxor S&P 500 VIX Futures Enhanced Roll (Lux) UCITS ETF (LVO), listed on Euronext, Borsa Italiana and Xetra. This Lyxor ETF track the S&P 500 VIX Futures Enhanced Roll Index, a second-generation volatility index that dynamically switches between a short-term VIX futures and a mid-term VIX futures, based on their relative implied volatility, in order to model a cost-efficient exposure to volatility in the broad equity market. With fees of 0.60% is cheaper than the Boost offering, but lacks the leverage factor, making it more expensive on exposure-adjusted basis.

In the US, the two most popular VIX-related ETPs are the iPath S&P 500 VIX Short-Term Futures ETN (NYSE: VXX) and the ProShares VIX Short-Term Futures ETF (NYSE: VIXY), which have over $1.5bn and $210m in assets respectively. Both offer exposure to a daily rolling long position in short-term VIX futures contracts and have total expense ratios of 0.89% and 0.85%, respectively.

Of course, VIX ETPs are just one way to protect against increases in volatility. Other options include precious metals ETPs, particularly those linked to gold, or low volatility or minimum variance ETFs which typically track stocks with lower volatility characteristics relative to the broader equity market.

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