Can VIX ETFs or ETNs Be Used to exploit volatility?
Exchange-traded notes (ETN) created to track the VIX index have issues with roll yield making them challenging for short term trading and outright risky for “investment”. But given their directional movement, it seems a good idea to continue to explore their potential use. (To learn more about the risks, read The Risks of Volatility ETNs: A Recent Incident and Underlying Issues.)
In “Easy Volatility Investing” Tony Cooper finds evidence that suggests traders may find volatility trading strategies applied to ETNs attractive can be useful for portfolio management. He explores the risk/reward of five volatility trading strategies including simple buy-and-hold, price momentum, futures roll yield capture, volatility risk premium capture and dynamic hedging applying the strategies to four VIX exchange-traded notes (ETN):
- iPath S&P 500 VIX Short-Term Futures ETN (VXX)
- VelocityShares Daily Inverse VIX Short-Term ETN (XIV)
- iPath S&P 500 VIX Medium-Term Futures ETN (VXZ)
- VelocityShares Daily Inverse VIX Medium-Term ETN (ZIV)
For many decades the only way to invest in volatility has been through trading options, futures, or variance swaps. But in recent years a number of volatility-related exchange traded Funds (ETFs) and Exchange Traded Notes (ETNs) have been launched which make volatility trading accessible to the retail investor and fund managers without the need to access futures markets. Our objective is to devise a trading strategy using them.We document where volatility returns come from, clearing up some misconception in the process. Then we illustrate five different strategies that will appeal to different investors. Four of the strategies are simple to describe and implement. All of the strategies have had extraordinary returns with high Sharpe Ratios and low correlation to the S&P5’08 in some cases negative correlation. The returns seems to be too good to be true – like picking up $100 bills in front of a steamroller – so we have a detailed discussion on the risks and the nature of the steamroller.We illustrate how these strategies can be incorporated into existing portfolios to reduce portfolio risk especially in times of crisis. They have positive exposure to the markets during good times and negative exposure during bad times. Unfortunately they do not always provide absolute returns and while reducing net portfolio drawdowns they can themselves have significant drawdowns. Still, we suggest that a traditional 60% equities, 40% bonds portfolio should be adjusted to 55% equities, 35% bonds, and 10% volatility.