Concerns around the eurozone sovereign debt crisis and the risks to the financial sector have sent the cost of hedging soaring.
Although the short-term CBOE Volatility index (Vix), the most commonly used proxy for volatility, is at 14.85, below its historic average of around 20, the volatility futures curve has moved close to record levels.
So, while on the face of it, owning the Vix at under 15 seems a no-brainer given the risks hanging over the market, last Wednesday’s close marked the third steepest contango reading for front and second month Vix futures ever. Therefore investors wishing to use Vix futures as a hedge for their portfolios face massive roll costs to maintain this protection when their first month futures expire.
One analyst, who preferred to remain anonymous, said: ‘Historically, 95% of options expire worthless and Vix futures strategies are not a means of beating the odds – there is no arbitrage.’
Several alternative ways to play the Vix are also fraught with problems. A number of exchange traded funds and products have been launched in recent years that attempt to track the Vix, but the issue of roll yield has seen their performance at times be wildly uncorrelated to the underlying index.
Barclays Capital has this week launched a product, the S&P 500 Dynamic Vix Futures Index Total Return, which is structured as a delta one note.
The firm’s Lisa Chaudhuri said the product aims to reduce the impact of the cost of roll by moving between short and medium-term Vix futures depending on whether the market is in contango or backwardation. ‘What you find is that the cost of carry on the short-term Vix is very high and on average this costs around 8%,’ she said.
‘Private clients have been wary of buying volatility due to concerns that they lose a lot of money on this roll cost if volatility doesn’t rise to offset this. What we are trying to do is come up with the second generation of volatility products following on from ETFs and ETNs, which focus on only one part of the curve.’
The note uses an automated strategy looking to benefit from the shape of the volatility curve, which has historically been indicative of the future direction of the Vix.
‘The initial answer was to look at the mid-term part of the curve, which is not as steep. But it is also not as responsive to changes in the Vix and a lot of investors have been unhappy because the sensitivity to volatility has not been as high as hoped.
‘So what the strategy is doing is looking at the term structure, ie, whether the curve is upward or downward sloping and the difference between the second and third months, which tends to be a reasonable indicator of how the Vix may perform in the future. The index utilises that theory to determine where allocation will be – whether we are fully in mid-term futures, long mid-term and short short-term to fund the position and reduce the cost of carry, or whether we hold both when the curve moves into backwardation and therefore generate a positive carry position.’
She said in back-testing, the strategy returned 9.5% over the past year compared to -11.4% from short-term futures and -9.9% from medium-term futures.
Heed the warnings
But Brolly said investors do need to be aware that the product is not just a long-only play
‘This product is attempting to try and reduce the cost of hedging by capitalising on where people have the most risk aversion. The front end is very steep and you can sell that on and earn a monthly return while owning a point further in the curve which is not as steep.’
‘Most of us have to think about the cost of hedging and the product is a rational way of holding protection while at the same time capitalising on other people’s greater need for protection by selling them near-term protection at a point in the curve that you are not as sensitive too.’
Stuart Fox (pictured), a structured products analyst at City Asset Management, says for many investors, put options may be more suitable, but he points out that more and more innovation is being seen in the market. ‘However, given the swift development of new volatility strategies in recent times, and the potentially rewarding diversification benefits of these products, it certainly pays to at least consider their application in multi-asset portfolios,’ he said.