Meditations on Volatility ETFs
Had you invested $10,000 in a volatility ETF, for example VIXY in the beginning of the year your investment would go from $10,000 to $6,500 in 3 months. If you look further it seems like ETFs that invest in volatility decrease in value over time. Similarly, one would expect ETFs that bet against volatility to benefit given that the volatility bettors are losing, however after 2018 they are both on the losing sides of the trade. How did we get here and is there a valid use case for volatility ETFs?
Why do volatility bettors seem like they are on this down path and grind toward zero?
It depends on the structure of the ETF, and the most common one is where an ETF invests in something called front month VIX futures. VIX futures essentially represent expected volatility of the market. Front month VIX futures are the first two available months of VIX futures, for example April VIX future and May VIX future. An ETF would buy both of these futures and that way achieve exposure to volatility movements.
The front two months usually decrease as the expiry approaches. This is known as a decay. Simply speaking, projecting volatility two months from now, there are many unknowns and as an example the market could be expected to move 10% in next two months. If projecting a market movement a week from now, one would usually be more confident, and estimate the market to move less than 10%. This is known as the decay. The same contract purchased two months ago (at 10% volatility), the closer it is to expiry the more likely it is that the implied volatility would be lower. ETFs purchase VIX contracts, and expiration is approaching, volatility investors need market events to happen before the expiry in order for VIX contracts to go up in value. Essentially, volatility investors seek disruptive events to take place in the market to keep the volatility elevated in order to make money.
Yet the upside is still limited. As the market gets volatile, VIX would go to the very high levels, implying that the market could move up more than usually. There is a point at which market participants start to feel that volatility is now getting too expensive and don’t expect market to move further, capping the upside.
While volatility investors want uncertainty to persists, what usually happens is that VIX overreacts before coming back down as market participants make sense of events that occurred, driving the volatility lower.
So what happens to investors shorting volatility? Shouldn’t they benefit?
Volatility sellers are investors that do not expect the market to move as much as volatility implies, and also do not expect big disruptive events that persist for awhile. One such event would be a Trade War where prolonged negotiations could lead to slow down in economy and a domino effect of events that could lead volatility to remain elevated.
Investors shorting volatility (ETF such as SVXY) sell VIX contracts to bet against volatility. Once VIX contract that was sold 2 months ago for expected 10% volatility movement comes closer to expiration the implied volatility should be lower given less time uncertainty as the instrument is closer to expiration. The seller has made a profit because they sold at 10% and now they are buying back cheaper. ETF sellers make small profits on the decay mentioned earlier, and hope that before expiry there won’t be big disruptive news in the market which would shoot the volatility up to 30%, 40% causing them to give up their gains.
This strategy has been quite sound for awhile and it was known to be a slow grind higher as you would collect on this decay as the time was passing. All up until early 2018, when volatility went from record lows to record highs. In 2017 the stock market moved 1% up or down only seven times. In first quarter of 2018 it happened 22 times! This caused the volatility sellers to incur large losses (80% to 90% in a few days) and erased all the gains accumulated over the past few years within two days!
On the flip-side volatility buyers have benefited in the short term, but as the market was returning to normal and time decay worked against them, they went back to losses.
In conclusion is there a use case for volatility ETFs?
For short term speculators, there could be some merit if trying to hedge or bet against an event that would be troubling for the market in the short term. In my view, for long term holders, it’s virtually impossible to justify either betting on volatility to go up (your enemy: the decay), or that volatility will go down (your ally: decay, your enemy: big market event that erases all your hard earned decay gains)