The VIX, which is listed on the Chicago Board Options Exchange, is based on real-time prices of options on the S&P 500 index, and is designed to reflect investors' consensus view of future (30-day) expected stock market volatility. Futures contracts on VIX were introduced in 2004. These futures cover various maturities, which creates a VIX term structure similar to that of interest rates observed in fixed-income markets. VIX futures are cash settled and, if held to maturity, provide direct exposure to 30-day implied S&P 500 volatility. As expected, volatility tends to spike in periods of market stress, making VIX futures potentially attractive as portfolio hedging tools.
Over longer holding periods, passive investments in VIX futures can prove quite costly for two main reasons:
- Negative carry
- Strong mean reversion properties of volatility
Negative cost of carry is a function of the term structure of VIX futures. Because the VIX term structure is generally positively sloped (i.e., “in contango”), each time a maturing VIX future contract is replaced with a new longer-dated contract, investors tend to sell low and buy high.
Additionally, volatility tends to mean revert, thus requiring an active approach in order to crystallize gains from a spike in VIX futures. More specifically, after the financial crisis passive allocations to VIX futures experienced substantial losses as equity market implied volatilities reverted toward lower, longer-term averages and the VIX term structure reverted back into contango. As an extreme example, an investor owning the front month VIX future contract between Sept. 22, 2008, and Nov. 20, 2008, would have gained 351% only to give all of the hedging profits plus 82% of the initial capital back over the next three years, ignoring transaction costs.
Active VIX futures strategies might alleviate some of these issues. For example, a tactical hedge signal derived from the term structure of the VIX index might allow investors to take advantage of spikes in the VIX while potentially offering downside protection during periods of low or falling equity market volatility. This may be achieved by not investing in VIX futures until the signal is triggered. In addition, this signal may provide a mechanism to systematically monetize profits before the index reverts to its normal levels. The risks of using a strategy such as the one described above include not having portfolio insurance every time there is a risk event as well as other implementation challenges.
If a passive strategy is selected, investors can try to minimize the negative cost of carry by choosing a point in the VIX futures curve where the slope is flatter. However, this does not protect from the other drawbacks mentioned.