Volatility as an asset class: VIX, VIX futures, and volatility ETPs

In short

A friend of mine once bought a fund with the word volatility in its name, thinking it would act like insurance for his stock account. He held it for two years and watched it shrink like a snowman in April. If you are holding one of these products, or thinking about it, you should know how they work before you put a dollar in. The VIX is a number, not a thing you can buy. The products people actually buy track futures contracts on that number, and those futures cost money to roll from month to month. That cost is real, and it comes out of the holder's pocket. Short term products can lose value even when fear in the market stays high. Read the prospectus first, since the fund company must spell out these risks there.

The whole of it

What it is

I once sat with a retired fellow who asked me, kindly, why his volatility fund went down on a day when the whole market was jumpy. It is a fair question, and a lot of good people have asked it. The VIX is an index published by Cboe, the exchange that created it. It is built from prices of S&P 500 index options, which are contracts that let buyers bet on or protect against stock moves. The index turns those prices into a single figure. That figure is the market's guess at how much the S&P 500 will swing over the next 30 days, stated as a yearly percent. A reading of 20 means the options market expects about a 20 percent annual swing.

You cannot buy the VIX itself. It is a calculation, like a thermometer reading. Nobody sells you a 72 degree day. So the industry built other things that try to follow it.

The first is the VIX futures contract, also run by Cboe Futures Exchange. A futures contract is an agreement to settle up at a set price on a set date. The second is the exchange traded product, or ETP, a fund or note that holds those futures and trades like a stock. You will see names like ETFs and ETNs. An ETN is a note, which means it is a debt promise from a bank, so the bank's credit matters too.

How it works

A farmer I know says you cannot eat a forecast. The same goes here. A volatility ETP holds futures, not the VIX, so it earns or loses based on futures prices. Those prices often sit above the VIX when markets are calm. This setup has a name, contango. It means later dated futures cost more than earlier ones.

Here is the catch. A futures contract ends. To stay invested, the fund sells the near contract and buys the next one. That is called a roll. If the next contract costs more, the fund pays up each time. If the VIX holds steady, the futures price slides down toward it as the date nears. The fund eats that slide, and the loss shows up in the share price.

The reverse setup is backwardation, where nearer futures cost more than later ones. That tends to appear in a panic. A product that rolls in backwardation can gain from the roll. But panics fade fast, and the product has to be held at the right time. Timing is hard. Ask anyone who has tried.

Some products use leverage, which means they aim for two or three times the daily move. Others are inverse, meaning they aim to rise when the futures fall. Both reset every day. That daily reset can make results over weeks look nothing like the headline promise. The fund companies say this plainly in their prospectuses, and the SEC has put out investor bulletins on leveraged and inverse products.

The numbers, and where to find yours

Folks like to know where to look, so here is the short list. The current VIX level is posted on Cboe's website. The futures prices and the contract calendar are on the Cboe Futures Exchange site. The cost to hold a fund is its expense ratio, shown on the fund's page and in its prospectus. Each fund also lists its roll schedule, its index, and its daily reset rules there.

Some figures are set by law or by the exchange and change over time. The margin an account must post to hold a VIX future is set by the clearing house and the broker, and it moves. For the current figure, check Cboe and your broker. The standard size of a VIX futures contract is a multiplier of the current figure, which the official source publishes each year times the index level. Futures traders may face position limits and reporting rules set by the CFTC, found at the current figure, which the official source publishes each year. Taxes work differently from stock. The tax rate on gains depends on how the product is built and how long it is held, and the IRS covers that in its publications on investment income. Check the fund's tax section too.

A worked example

My neighbor Ruth has an after tax brokerage account. She puts $10,000 into a fund that holds one month VIX futures. She reads in the paper that the VIX sits near 15, and she figures it cannot fall much. She is right. It stays at 15 for the whole year.

The fund still loses money. Say each month the fund sells a contract at $15.00 and buys the next at $16.00. That is a $1.00 cost on a $16.00 contract, or $1.00 divided by $16.00, which is 6.25 percent per roll. Her $10,000 shrinks by 6.25 percent, leaving $9,375 after the first roll.

Over twelve rolls the damage grows. Each month she keeps 93.75 percent of what she had. After two months, $9,375 times 0.9375 is about $8,789. After three, it is about $8,240. After twelve months, $10,000 times 0.9375 twelve times comes to about $4,610. The VIX never moved. Her account lost more than half.

Now take the fund's expense ratio. If it is 0.95 percent, that is $95 a year on $10,000, or about $44 on her $4,610 by year end. Small next to the roll cost, but it adds up. Ruth did nothing wrong in her thinking about the index. She just did not know the product tracks futures, and futures carry a price tag of their own.

This is only an illustration with round figures. Real roll costs change every month, and sometimes they help the holder. That is the point. They swing, and the holder has no say in it.

Where it goes wrong

I have made my share of mistakes with money, so I speak as a fellow traveler here. The first slip is thinking the product equals the index. It does not. The second is thinking it works as a long term hedge. The roll cost wears at it, and the daily reset on leveraged and inverse versions makes long holding worse. Prospectuses say these products are meant for short holding periods. Read that part twice.

A third slip is ignoring the issuer. If the product is an ETN, the bank must pay back the note, and if the bank fails, the holder is a creditor in line. A fourth is crowding in after a spike. By the time headlines scream, futures prices have often jumped, and the new buyer pays a high price for protection that may already be fading. Spikes can reverse in days.

There have been blowups. In February 2018, an inverse volatility note tied to the VIX lost most of its value in a single day, and the issuer later closed it. Anyone curious can find the prospectus language that warned of this. It was in print all along, which is a lesson in itself.

Last, tax surprises. Gains and losses may be taxed in ways a stock holder does not expect, and the paperwork can differ. A tax preparer or the IRS publications can sort that out.

Questions to answer before you leave this page

Do you know whether the product you are looking at holds futures, or is a note backed by a bank? Have you read the prospectus section on how the fund rolls its contracts and what that costs? Can you say in one sentence why the fund might fall while the VIX stays flat? Does the product reset daily, and do you understand what that does over a month? If it is an ETN, have you looked at who issues it and how strong that company is? What is the expense ratio, and have you added it to the roll cost to see the full price of holding? Do you know how gains from this product are taxed in your account? And is there a plain reason you want it, one you could explain to a neighbor over coffee without needing a chart?