The Vix and Futures
Investors often worry about market volatility. One hedging strategy is to look for investments that increase in value when markets decline in order to get some downside protection.
VIX is an abbreviation for “volatility index.” Its actual calculation is complicated, but the basic goal is to measure how much volatility investors expect to see in the S&P 500 over the next 30 days, based on prices of S&P 500 Index options. When options traders think the stock market is likely to be calm, the VIX is low; when they expect big swings in the market, the VIX goes up.
VIX Index
[Select Dates during Select Years]
|
1995 |
13 |
|
2007 |
10 |
|
1998 |
36 |
|
2008 |
61 |
|
2000 |
20 |
|
2010 |
19 |
|
2002 |
20 |
|
2011 |
16 |
|
2004 |
15 |
|
2012 |
19 |
During times of high market turmoil, the VIX has tended to rise. The VIX index moved steadily higher as the market approached the peak of the late 1990s technology bubble, calmed down during the steady growth period of 2003–2007, then spiked during the 2008 credit crisis and also in the latter half of 2011. Because of this pattern of behavior, the VIX is sometimes referred to as the fear index; when market participants are worried about the market, the VIX tends to rise.
Investors who see the VIX having increased sharply while the market went down might be tempted to seek an investment in the VIX as a source of potential protection during market turbulence.
Like all indexes, you cannot directly buy. Moreover, unlike a stock index such as the S&P 500, you cannot buy a basket of underlying components to mimic the VIX. Instead, the only way investors can access the VIX is through futures contracts.
Index futures, such as those tied to the value of an index like the S&P or VIX, do not involve the actual delivery of anything when the futures contract matures. Instead, they use a cash delivery tied to the value of the index on the delivery date.
Contango
The potential problem, as with any futures contract, is contango—when the futures price for something is > its current price. For example, if VIX is at 15 today and a one-month VIX futures contract is trading at 16, the VIX futures market is in contango.
Imagine your goal is to always have a certain part of your portfolio invested in VIX futures. If the futures contracts are always more expensive than the current VIX level, then you pay a premium every time you buy futures. You are essentially buying high and selling low, which erodes the value of your investment over time.
Contango is not purely academic. VIX futures contracts have often been more expensive than the VIX index. According to Bloomberg, in 50 of the past 73 months, the three-month VIX futures contract was above the VIX level—68% of the time over a period just over six years.
In the table below, you can see what $10,000 would be worth if it had been invested in the VIX itself versus a portfolio of short-term VIX futures contracts. These portfolios are based on actual ETFs that buy VIX futures contracts.
Value of $10,000 Investment
[Short-Term VIX Futures vs. VIX Index]
|
|
S.T. VIX |
VIX Index |
|
|
S.T. VIX |
VIX Index |
|
Apr. 2011 |
$10k |
$10k |
|
Jan. 2012 |
$12k |
$14k |
|
July 2011 |
$10k |
$11k |
|
Apr. 2012 |
$7k |
$11k |
|
Oct. 2011 |
$24k |
$28k |
|
July 2012 |
$5k |
$13k |
Since April 2011, the futures contracts have lagged significantly behind the value of the VIX index. By the end of the time period, the value of $10,000 hypothetically invested in the VIX itself would have risen to almost $13,000 while the portfolios of futures contracts were worth $5,500. Had an investor actually been able to buy the VIX, the investment would have paid off during this time period; the actual investable instruments lost significant amounts of money.
Just because an investment has VIX in its name does not mean that it will move in line with the VIX index. The VIX itself can be extremely volatile—the index lost 64% of its value between September 2011 and March 2012.