Barclays Opens a Brand New Asset Class

How Do You Index What You Can't See?
Virtually all the indexes that we use on a daily basis rely on the most transparent attribute of any stock: its price. Every weekday, millions of investors, traders, and speculators make their best guesses as to the worth of tens of thousands of listed companies. These guesses, in the forms of bid and ask prices, average into a market price that provides a collective estimate of the company's worth. But as an average, the price ignores another helpful piece of information, which is the certainty of those guesses. That is what volatility roughly estimates. If the value of a particular company is extremely certain, it will have very low volatility because anyone looking to sell could find plenty of buyers at a slightly below-average price while anyone willing to buy would find a deep pool of sellers at a slightly above-average price. If no one can value the company very precisely, market participants are far less willing to make large bets on the stock, so major sellers need to lower their acceptable price even farther and major buyers need to raise their acceptable bids to find investors for the other side of their trades. This drives higher volatility as market prices oscillate wildly with the sentiment of marginal traders.

Volatility certainly provides some useful information then, but how do we isolate it? We can look at the variation in the market price over trailing time periods, known as the "realized volatility," but that is a backward-looking measure. We would rather use an estimate about the future volatility, similar to how a stock price captures an estimate of future profitability and cash flows. Fortunately, the market provides these estimates through the large and vibrant trade in index options.

Future gyrations in stock prices drive the value of options, with higher instability making them more valuable. Think about a call option on the S&P 500 at a value of 800. If the only possible future values in a month are 850 or 750, and they are equally likely, that option is worth $25 as there is a one half chance it will be worth $50 and one half chance it will expire worthless. If volatility rises, so the possible future values are now 900, 850, 750, or 700, and they are all still equally likely, the call option is now worth $37.50 because it has a one quarter chance of being worth $100, one quarter chance of being worth $50, and one half chance of expiring worthless. The math that goes into valuing actual options is far more complex due to the nearly infinite possible future prices, but it requires an estimate of how large future price movements will be. It is possible to reverse this process, taking the resulting option prices and extracting the volatility estimates that produced them. Every month, the Chicago Board Option Exchange crunches the numbers on the market prices of their S&P 500 Index options to produce the market's own estimate of the S&P 500's volatility over the next month. This estimate of instability in the near term is published as the VIX index, and is the most widely followed measure of market sentiment.

So Why Would a Long-Term Investor Care?
Predictions of short-term volatility may not seem very helpful to anyone with a multiyear time horizon for their portfolio. After all, the variation of prices in one month will not matter much when you plan to hold your investments for five years or more. But due to the way market prices and volatility interact, it also has some great uses for sophisticated investors looking to manage their asset allocations. Volatility measures such as the VIX provide an excellent proxy for the amount of uncertainty in the market, and if there's anything the stock market does not like, it's uncertainty. Think about if you were asked to bid on a pure gold coin that you could weight and assay and knew had $100 worth of gold in it. I bet you would gladly bid $99.50 for that coin. Now, imagine instead you were bidding on a coin that was about twice as heavy and looked like 14 karat gold, but it could be only 10 karat or it could be 20. The expected value would be about the same as the assayed coin, but I know that I would bid much lower. Greater uncertainty as to the coin's true value substantially lowers its price, even if we can reasonably expect it to have the same value on average. The same effect occurs in the stock market, which is why volatility spikes and price crashes go hand-in-hand.

This relationship between volatility and prices makes the VIX one of the best diversifiers for an equity portfolio in existence. Some assets like commodities and government bonds show near-zero correlation, but volatility has a strong negative correlation with stock prices. Unfortunately, like any other incredible insurance, you need to pay up. The VIX over time has shown strong mean-reversion, which means that it always returns to an average value that hovers around 25. During periods of low risk and small market movements, it sits down at lows below 20. During crashes and extreme dislocations, it will skyrocket to values of 40 or higher. But most of the time it just hovers in between. Ultimately, it will not produce any long-term gains because the market does not grow structurally more risky with time. Thus you pay for the insurance of a volatility position by tying up part of your portfolio in a non-appreciating asset class and accepting the drag on your overall returns.

Why Do These ETNs Only "Almost" Invest in Volatility?
That one-word caveat in the first sentence of this article requires a whole lot of explanation. These ETNs do not actually attempt to track the VIX index itself. Tracking the index would require massive, expensive turnover on a portfolio of options, and would likely still incur large tracking error due to the difficulty of buying the less liquid contracts. However, the Chicago Board Options Exchange also carries futures on where the VIX index will trade near the end of each forthcoming month. Institutions frequently use these futures to hedge their volatility exposure, producing visible, accurate prices for the ETNs to track throughout the trading day.

The major drawback to the VIX futures is their negative roll yield. Because firms tend to buy these futures as insurance on their equity portfolio, they are willing to overpay slightly for the future protection. Just like anyone else buying insurance, the trader buying the VIX future will pay a higher price than current volatility so the seller can expect a profit on average. As the expiration date on the futures approaches, their insurance value deteriorates, and so does their premium to current volatility. This means that, whereas volatility will typically produce an expected return of zero during stable markets, a basket of rolling volatility futures such as those tracked by these new iPath ETNs will actually produce a negative return. The yield on the cash that serves as collateral for the futures helps dampen the losses, but not fully.

Because futures price for expected future volatility, they also tend to not move as sharply as current volatility. When current volatility is low, futures prices remain higher due to their insurance premium. When current volatility is high, futures prices stay lower to account for expected mean-reversion and slightly calmer markets in a few months' time. The short-term contracts tracked by VXX follow spikes in current volatility more closely than the mid-term contracts and have as strong of a negative correlation with the S&P 500 as current volatility, but investors should not expect their futures positions to appreciate 150% when the VIX spikes from 30 to 80 as it did in September and October of last year. The mid-term contracts tracked by VXZ provide even less exposure to the sharp movements of current volatility, but in return they have a less negative roll yield. So this ETN will lose less in normal times than its short-term contracts cousin while providing less insurance during major downturns.

Nothing Comes for Free
Ultimately, these drawbacks to the VIX futures just illustrate that there is no free lunch in investing. If you want returns, you need to pay for them with risk. If you want insurance, you need to pay for it by giving up returns. The trick is finding the right balance. We believe these new ETNs could provide an interesting new tool for asset allocators who want a small slug of insurance against any sudden market crashes. However, due to their complex structure and the current worries about ETNs, we would suggest that only the most sophisticated investors try to find a place in their portfolio for these funds. Even those who understand the risk and return of these instruments should put up only small stakes to avoid a heavy drag on potential returns given today's promising bond and equity prices. Buying volatility at 40 has rarely paid off in the past, and unless we face another October/November 2008, it will not do well in the future either.

 

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