#4 What Didn't Work in 2012

Posted on January 15th, 2013

Hedging with Volatility ETFs is #4 on our list of tactics that didn't work in 2012.

2012 saw increased flows of assets into volatility-based vehicles. The most popular by volume is the iPath S&P 500 VIX Short-Term Futures ETN (VXX), but others include ProShares Short-term Futures ETF (VIXY), VelocityShares Daily 2x VIX Short Term ETN (TVIX) and Ultra VIX Short-Term Futures ETF (UVXY). Despite the inflows, these ETFs all underperformed miserably, not only to the broad market, but against the VIX Index as well.
Let’s put this into perspective; these are not investment vehicles. They tradable assets designed to provide protection against spikes in volatility usually associated with down markets. They are all based on the VIX futures and as traders learned, can have disassociation with the index itself. Here is a chart of these 4 exchange traded vehicles against the VIX:

In case you’re looking for confirmation on what this chart says; yes, the VIX was down year-over-year by 40% while VXX & VIXY were down 80% and TVIX & UVXY were down by more than 95%.
Hedges losing money in an up year is a very common occurrence. Actually, one would expect hedges to lose money as their main assets grow. That’s kind of the point. However, the volatility ETFs weren’t able to provide any kind of long term protection last year.  The only way to make them pay was to time their purchase just right ahead of a spike in volatility.
Looking at May 1st to June 4th when the market experienced a 10% decline, we saw a spike in volatility of nearly 60% as the VIX went from 17 to 27. VXX was up 35% and TVIX was up 55% over that same time. Not bad if you can time it. However, if you had been in the trade one month before to one month after (April to July) the results would have been dramatically different. The VIX was virtually flat over that time, up 5%, but VXX was down 18% and TVIX was down 40%. You can see how important timing is to making these vehicles work and timing hedges is not a hedging strategy; it’s a trading strategy.
Why does this happen? If these vehicles are designed to trade with the index, how can they underperform so dramatically? The answer is that since the VIX itself is only an index and not an asset that can be purchased or held in a fund. So these exchange-traded products need to use the futures as their means of actually holding something in the fund or note. And if you’ve ever read our stuff about futures-based ETFs and ETNs then you know that there can be a time to price disconnect in the futures from month to month known as contango. This is where further out months have a higher value than the near month futures.  As the farther out months get shorter in time, the futures depreciate to align with the spot price. Hence, contango causes these vehicles to depreciate even if the VIX stays flat.
These products also bring some additional risks associated with the way they are constructed. TVIX was a good example of that in March 2012 when Credit Suisse decided to halt issuance of new units for its ETN due to size limits. When the news of this broke, TVIX plummeted from 15 down to 6 in a period of 3 days.  Eventually CS resumed issuance, but it has been a poster child for understanding what you’re trading and knowing there are more risks than just the contango of futures and the unpredictability of the markets.
As far as trading vehicles go, the products are not for the faint of heart. And for sure, as far as hedging goes, these vehicles are not designed to protect a long term portfolio. So don’t let their names confuse you into adding them into your allocation and protection plans. If you want to trade them go ahead and have fun, it is actually a micro-sector that has some interesting volatility, unlike the rest of the broad markets.  However, when it comes to hedging, there are much better ways to do it.

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