We cannot tell if the timing is superb or terrible, but individual investors can finally invest (almost) directly in the volatility of European shares now that Barclays has launched the iPath VSTOXX Short-Term Futures Total Return ETN. The fund seeks to replicate the performance of the EURO STOXX 50 Volatility Short-Term Futures Total Return Index, which is the first of its kind in Europe and has been licensed exclusively to Barclays. The ETN is listed on XETRA and sports a total expense ratio of 0.89%. It joins two existing Barclays ETNs already listed on XETRA which track the near- and mid-term futures on the S&P 500 VIX--the chief barometer of US stock market volatility.
While the most recent crash reminded us all why volatility is the ultimate diversifier, it has also made investors wary of ETNs and the credit risk they carry. However, these intriguing new exchange-traded products allow access to an exotic asset class that used to be the sole preserve of institutions that could trade complex options strategies or enormous futures contracts. Strategic stakes in volatility could help sophisticated investors protect their portfolio from the next big crash, which is why we called out for these funds in September of 2008. Now that they have arrived, we wish to take the opportunity to elucidate how these new indices work, why we were so excited about the prospect of a volatility investment in the first place, and why you shouldn't rush to invest just yet.
How Do You Index What You Can't See?
Virtually all the equity indices that we use on a daily basis rely on the most transparent attribute of any share: its price. Every weekday, millions of investors, traders, and speculators make their best guesses as to the worth of tens of thousands of listed companies. These guesses, in the forms of bid and ask prices, average into a market price that provides a collective estimate of the company's worth. But as an average, the price ignores another helpful piece of information, which is the certainty of those guesses. That is what volatility roughly estimates. If the value of a particular company is extremely certain, it will have very low volatility because anyone looking to sell could find plenty of buyers at a slightly below-average price while anyone willing to buy would find a deep pool of sellers at a slightly above-average price. If no one can value the company very precisely, market participants are far less willing to make large bets on the shares, so major sellers need to lower their acceptable price even farther and major buyers need to raise their acceptable bids to find investors for the other side of their trades. This drives higher volatility as market prices oscillate wildly with the sentiment of marginal traders.
Volatility certainly provides some useful information then, but how do we isolate it? We can look at the variation in the market price over trailing time periods, known as the "realised volatility," but that is a backward-looking measure. We would rather use an estimate about the future volatility, similar to how a stock price captures an estimate of future profitability and cash flows. Fortunately, the market provides these estimates through the large and vibrant trade in index options.
Future gyrations in stock prices drive the value of options, with higher instability making them more valuable. Think about a call option on the EURO STOXX 50 at a value of 2800. If the only possible future values in a month are 2950 or 2650, and they are equally likely, that option is worth €75 as there is a one half chance it will be worth €150 and one half chance it will expire worthless. If volatility rises, so the possible future values are now 3000, 2950, 2650, or 2600, and they are all still equally likely, the call option is now worth €87.50 because it has a one quarter chance of being worth €200, one quarter chance of being worth €150, and one half chance of expiring worthless. The maths that goes into valuing actual options is far more complex due to the nearly infinite possible future prices, but it requires an estimate of how large future price movements will be. It is possible to reverse this process, taking the resulting option prices and extracting the volatility estimates that produced them.
During VSTOXX calculation hours (08:50 to 17:30 CET) the index’s value is calculated by crunching numbers on the value of the EURO STOXX 50 index, best bid and ask prices for all EURO STOXX 50 options, Euro Overnight Index Average (EONIA), Euro Interbank Offered Rates (EURIBOR), and REX. What comes out the other end of this calculation is the headline VSTOXX figure.
So Why Would a Long-Term Investor Care?
Predictions of short-term volatility may not seem very helpful to anyone with a multiyear time horizon for their portfolio. After all, the variation of prices in one month will not matter much when you plan to hold your investments for five years or more. But due to the way market prices and volatility interact, it also has some great uses for sophisticated investors looking to manage their asset allocations. Volatility measures such as the VSTOXX provide an excellent proxy for the amount of uncertainty in the market, and if there's anything the stock market does not like, it's uncertainty. Think about if you were asked to bid on a pure gold coin that you could weight and assay and knew had £100 worth of gold in it. I bet you would gladly bid £99.50 for that coin. Now, imagine instead you were bidding on a coin that was about twice as heavy and looked like 14 carat gold, but it could be only 10 carat or it could be 20. The expected value would be about the same as the assayed coin, but I know that I would bid much lower. Greater uncertainty as to the coin's true value substantially lowers its price, even if we can reasonably expect it to have the same value on average. The same effect occurs in the stock market, which is why volatility spikes and price crashes go hand-in-hand.
This relationship between volatility and prices makes the VSTOXX one of the best diversifiers for an equity portfolio in existence. Some assets like commodities and government bonds show near-zero correlation, but volatility has a strong negative correlation with stock prices. Unfortunately, like any other incredible insurance, you need to pay up. The VSTOXX over time has shown strong mean-reversion, which means that it always returns to an average value that hovers around 26. During periods of low risk and small market movements, it sits down at lows below 20. During crashes and extreme dislocations, it will skyrocket to values of 40 or higher. But most of the time it just hovers in between. Ultimately, it will not produce any long-term gains because the market does not grow structurally more risky with time. Thus you pay for the insurance of a volatility position by tying up part of your portfolio in a non-appreciating asset class and accepting the drag on your overall returns.
Why Do These ETNs Only "Almost" Invest in Volatility?
That one-word caveat in the first sentence of this article requires a whole lot of explanation. These ETNs do not actually attempt to track the VSTOXX index itself. Tracking the index would require massive, expensive turnover on a portfolio of options, and would likely still incur large tracking error due to the difficulty of buying the less liquid contracts. However, Eurex carries futures on where the VSTOXX index will trade near the end of each forthcoming month. Institutions frequently use these futures to hedge their volatility exposure or insure against a market crash, producing visible, accurate prices for the ETNs to track throughout the trading day.
The major drawback to the VSTOXX futures is their negative roll yield. Because firms tend to buy these futures as insurance on their equity portfolio, they are generally willing to overpay slightly for the future protection. Just like anyone else buying insurance, the trader buying the VSTOXX future will pay a higher price than current volatility so the seller can expect a profit on average. As the expiration date on the futures approaches, their insurance value deteriorates, and so does their premium to current volatility. This means that, whereas volatility will typically produce an expected return of zero during stable markets, a basket of rolling volatility futures such as those tracked by these new iPath ETNs will actually produce a negative return. The yield on the cash that serves as collateral for the futures helps dampen the losses, but not fully.
Because futures prices account for expected future volatility, they also tend to not move as sharply as current volatility. When current volatility is low, futures prices remain higher due to their insurance premium. When current volatility is high, futures prices stay lower to account for expected mean-reversion and slightly calmer markets in a few months' time. The short-term contracts tracked by VSTOXX follow spikes in current volatility more closely than the contracts for farther out in time, and they have as strong of a negative correlation with the EURO STOXX 50 as current volatility. But investors should not expect their futures positions to appreciate 150% when the VSTOXX spikes from 22 to 87 as it did in September and October of last year. Also, the more frequent turnover of short-term futures contracts will exacerbate the negative returns from a declining insurance premium.
Nothing Comes for Free
Ultimately, these drawbacks to the VSTOXX futures ETN just illustrate that there is no free lunch in investing. If you want returns, you need to pay for them with risk. If you want insurance, you need to pay for it by giving up returns. The trick is finding the right balance. We believe this new ETN could provide an interesting new tool for asset allocators who want a small slug of insurance against any sudden market crashes. However, due to its complex structure and worries about ETNs' degree of counterparty risk, we would suggest that only the most sophisticated investors try to find a place in their portfolio for these funds. Even those who understand the risk and return of these instruments should put up only small stakes to avoid a heavy drag on potential returns. Investors have pushed up volatility futures prices for the past couple of years due to fear of another stock market dip, which has produced astonishingly bad returns for the US-listed ETNs tracking the similar VIX futures index. Buying volatility at 35 has rarely paid off in the past, and unless we face another October/November 2008, it will not do well in the future either.
Ben Johnson contributed to this article.
