Volatility (VIX Based)Exchange Traded Funds (ETFs) & Notes (ETNs)

An overview

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Volatility is emerging as an important asset class because:

• It offers diversification benefits due to its negative correlation with the S&P 500• There are now several VIX based products available that give retail investors

access to this asset class for the first time

However, the diversification benefits of VIX come at a cost• Most VIX based funds roll short-term futures contracts into longer-term futures

contracts• The average daily roll cost is 0.16% and 0.02% for the Short-Term &

Mid- ‐Term indices respectively for the 2005- ‐2010 period

For investors going long volatility, the Mid-term VIX offers the same diversification benefits but much lower roll cost than the Short-term VIX.

Executive Summary

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Measuring volatility: The VIX Index

• The most widely adopted measure of US stock market volatility is the VIX index (often referred to as the ‘fear gauge’ in the media)

• It measures the expected volatility in the S&P 500 Index over the next 30 days. In a traditional stock index like the S&P 500, the components of the index are the 500 individual stocks. By contrast, the VIX Index is comprised of call and put options rather than stocks

• It is important to remember that VIX measures investors’ expectations of volatility (implied volatility) rather than actual historical volatility. The chart on Slide 3 shows the historical trend in the VIX since its introduction in 1991

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Chart I: Historical VIX Index Values• The historical average (median) VIX value is 19.04• The 90‐percentile cutoff is 30.12 i.e. the VIX has exceeded that value

on only 10% of all trading days since its inception

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• Historically, retail investors have reacted to periods of uncertainty by moving out of equities and into cash

• Studies such as the annual QAIB report from Dalbar show that poor market timing during periods of uncertainty results in lower long-term returns 

A consequence of volatility: Poor market timing

Time Period Average VIX Value % of Trading Days with >1% change in S&P 500

Historical Average 20.5* 23.07%**

‘Post Lehman’(Sep ’08 – May ’09)

45.8 70%

‘Mid year 2010’(May ’10 – June ’10)

31.2 60%

Table 1: Recent periods of increased volatility

* 1990 to November 2011, data sourced from CBOE; ** 1928 – 2011, data sourced from S&P

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The diversification benefits of volatility

• One of the features of volatility as an asset class is its strong negative correlation with the S&P 500.

• The VIX Index and the S&P 500 have a -76% correlation based on the past 5 years of historical index data.

• VIX index returns are usually positive on days when the S&P 500 shows a sharp decline of >1%.

• The chart on Slide 6 shows the 21 trading day rolling correlation between the spot VIX Index and the S&P 500 over the past 5 years. This indicates that volatility can be viewed as a distinct asset class that could offer diversification benefits to investors in a broad equity portfolio.

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Chart II: VIX – 21 Trading Day RollingCorrelation with S&P 500

10/19/20063/12/2007 7/27/200712/12/2007 5/1/2008 9/17/2008 2/4/2009 6/23/2009 11/6/2009 3/29/2010 8/13/201012/30/20105/18/2011 10/4/2011-1.20

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• The negative correlations of the VIX index make it a potentially good way to diversify a portfolio. However there is no easy way to access the ‘spot’ market for volatility.

• One approach now available is to buy funds that hold VIX futures contracts. This is similar to the commodities markets – retail investors cannot easily buy, store and sell natural gas, but can invest in funds that hold natural gas futures.

• In the last few years, indices have been introduced that model a strategy of holding VIX futures.– For example, the S&P 500 VIX Short-Term Futures Index measures the

return from holding first and second month VIX futures contracts. The index maintains a constant one-month maturity.

– Similarly, the S&P 500 VIX Mid-Term Futures Index holds fourth, fifth, sixth and seventh month futures contracts, while maintaining a constant five-month maturity.

Accessing Volatility through index based products

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• It is important to remember that futures based products will have different return characteristics than getting direct exposure to ‘spot’ VIX.

• However they can still serve as a useful proxy. The Short-Term & Mid-Term VIX Futures Indices have a high correlation with spot VIX and negative correlations with the S&P 500.

Accessing Volatility through index based products

S&P 500 Short Term VIX Mid Term VIX VIXS&P 500 100%      Short Term VIX -80% 100%    Mid Term VIX -78% 90% 100%  VIX -76% 88% 80% 100%

Table 2: Correlations between S&P 500 & VIX Based Indices(Dec. 2005 – Nov. 2011)

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Understanding Index Roll

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Chart III: VIX Futures Index – Roll Example

• An example: S&P 500 Short Term Futures Index• The long futures position is rolled every day from the first month to

second month futures in equal fractional amounts.

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Roll Cost

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Chart IV: Short Term and Mid Term Historical Index Levels

• Rolling near-month VIX futures contracts into next-month contracts can result in a loss in portfolio value.

• For e.g. 2007, on an average 0.126% of the Short- ‐term Futures Index value was lost daily due to the index roll.

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As of Dec 7, 2011, there were 4 ETFs and 26 ETNs. The table below lists a few of these for purposes of comparison.

Product Comparison

ProShares VIX Short-Term Futures ETF

ProShares Short VIX Short-Term

Futures ETF

ProSharesVIX Mid-Term Futures ETF

iPath S&P 500 Dynamic VIX ETN

Ticker Symbol VIXY SVXY VIXM XVZInvestment Objective Match the 

performance of the S&P 500 VIX Short-Term Futures Index

Inverse (-1x) of the performance of the S&P 500 VIX Short-Term Futures Index

Match the performance of the S&P 500 VIX Mid-Term Futures Index

Match the performance of the S&P 500 Dynamic VIX Futures Total Return Index

Expense Ratio 0.85% 0.95% 0.85% 0.95%

Fund structure Delaware statutory trust

Delaware statutory trust

Delaware statutory trust

Exchange Traded Note (ETN)

Average settlement date of underlying VIX futures contract

1 month 1 month 5 months Variable

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Product Comparison (cont.)

Below are some of the key features that should be considered when comparing funds:

Fund structure: Unlike ETFs, ETNs are debt instruments. The investor is taking on the credit risk of the issuer and should also look at their creditworthiness.

Maturity of futures contract: One of the consequences of the maturity period is the roll cost. Short-term indices can have a high roll cost which can offer portfolio performance while still providing diversification benefits.

Roll Mechanism: If roll cost is a significant consideration, investors could consider products that attempt to minimize daily roll cost.

Correlation with underlying index: Some VIX-based funds simply try to replicate a long position in the underlying index. Others may adopt an inverse strategy, where the daily return of the fund is directionally opposite to the daily index return.

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• What practical implications does our analysis have for investors? One conclusion is that for investors considering long VIX exposure, the mid-term VIX product VIXM appears to offer the same diversification benefits as the short term VIXY, but at a much lower roll cost.

• In order to see the effect of including a VIX futures based fund, we looked at a hypothetical equity portfolio holding US (S&P 500) and global developed (EAFE) equities.

• In our base case, our portfolio holds largely (90%) the S&P 500 and has some exposure (10%) to EAFE, and has a historical annualized return of -0.76% with a standard deviation of 22.27% and Sharpe Ratio of -0.05.

Trading & Investment Opportunities

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Trading & Investment Opportunities (cont.)

Mid Term VIXIndex weight

Return Standard Dev Sharpe Ratio

-0.76% 22.27% -0.050 -0.76% 22.27% -0.05

0.1 0.07% 20.08% -0.010.2 0.91% 18.50% 0.030.3 1.74% 17.71% 0.08

Short Term VIXIndex weight

Return StandardDev Sharpe Ratio

-0.76% 22.27% -0.050 -0.76% 22.27% -0.05

0.1 -3.56% 20.69% -0.190.2 -6.36% 21.04% -0.320.3 -9.16% 23.24% -0.41

If 20% of the portfolio is allocated to the Mid-Term VIX Futures Index, the return  improves  to  0.91%  and  the Sharpe  ratio  to  0.03  (Table  4).  This does  not  however  hold  when  the Short-Term  Index,  likely  due  to  its strong  negative  return  over  the period and high standard deviation. 

Investors  could  instead  consider including  the  inverse  short  term VIX  (SVXY)  to  their  portfolio,  or consider  a product  like XVIX  that goes  long  the Mid-term  VIX  and short the Short-term VIX.

Table 4 – Adding Mid-Term VIX to a portfolio

Table 5 – Adding Short-Term VIX to a portfolio

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Appendix – Product List

Investment ObjectiveAnnual Expense

Ratio/Investor Fee Fund StructureAverage Futures

MaturityVIXY Match the performance of the S&P 500 VIX 

Short-Term Futures TR Index0.85% Delaware 

statutory trust1 month

SVXY Inverse (-1x) of the daily performance of the S&P 500 VIX Short-Term Futures TR Index

0.95% Delaware statutory trust

1 month

VIXM Match the performance of the S&P 500 VIX Mid-Term Futures TR Index

0.85% Delaware statutory trust

5 months

UVXY Match twice (2x) the daily performance of the S&P 500 VIX Short-Term Futures Index

0.95% Delaware statutory trust

1 month

VXX Linked to the performance of the S&P 500 VIX Short-Term Futures TR Index

0.85% Note (Unsecured debt)

1 month

XXV Linked to the inverse performance of the S&P 500 VIX Short-Term Futures Index Excess Return

0.89% Note (Unsecured debt)

1 month

VZZB Match the daily performance of the S&P 500 VIX Mid-Term Futures Index TR

0.89% Note (Unsecured debt)

5 months

VXZ Match the daily performance of the S&P 500 VIX Mid-Term Futures Index TR

0.89% Note (Unsecured debt)

5 months

XVZ Dynamically allocates between the S&P 500® VIX Short-Term Futures Index ER and the S&P 500 VIX Mid-Term Future Index ER by monitoring the steepness of the implied volatility curve

0.95% Note (Unsecured debt)

Variable

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Appendix – Product List

Investment ObjectiveAnnual Expense

Ratio/Investor Fee Fund StructureAverage Futures

MaturityIVOP Inverse exposure to the S&P 500 VIX Short-

Term Futures Index Excess Return.0.89% Note (Unsecured 

debt)1 month

TVIX Match twice (2x) the daily performance of the S&P 500 VIX Short-Term Futures Index ER

1.65% 

Note (Unsecured debt)

1 month

VIIX Match the daily performance of the S&P 500 VIX Short-Term Futures Index ER

0.89% Note (Unsecured debt)

1 month

XIV Match the inverse of the daily performance of the S&P 500 VIX Short-Term Futures Index ER

1.35% Note (Unsecured debt)

1 month

TVIZ Match twice (2x) the daily performance of the S&P 500 VIX Mid-Term Futures Index ER

1.65% 

Note (Unsecured debt)

5 months

VIIZ Match the daily performance of the S&P 500 VIX Mid-Term Futures Index ER

0.89% Note (Unsecured debt)

5 months

ZIV Match the inverse of the daily performance of the S&P 500 VIX Mid- Term Futures Index ER

1.35% Note (Unsecured debt)

5 months

VXAA Match the daily performance of the S&P 500 VIX Short-Term Futures Index TR

0.85% Note (Unsecured debt)

1 month

VXEE Match the daily performance of the S&P 500 VIX 5-Month Futures Index TR

0.85% Note (Unsecured debt)

5 months

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Appendix – Product List

Investment ObjectiveAnnual Expense

Ratio/Investor Fee Fund StructureAverage Futures

MaturityVXFF Match the daily performance of the S&P 500 

VIX 6-Month Futures Index TR0.85% Note (Unsecured 

debt)6 months

AAVX Short (inverse) exposure to the performance of the S&P 500 VIX Short-Term Futures Index ER

1.35% Note (Unsecured debt)

1 month

BBVX Short (inverse) exposure to the performance of the 2-Month Futures Index ER

1.35% Note (Unsecured debt)

2 months

CCVX Short (inverse) exposure to the performance of the 3-Month Futures Index ER

1.35% Note (Unsecured debt)

3 months

DDVX Short (inverse) exposure to the performance of the 4-Month Futures Index ER

1.35% Note (Unsecured debt)

4 months

EEVX Short (inverse) exposure to the performance of the 5-Month Futures Index ER

1.35% Note (Unsecured debt)

5 months

FFVX Short (inverse) exposure to the performance of the 6-Month Futures Index ER

1.35% Note (Unsecured debt)

6 months

XVIX Linked to the performance of the S&P 500 VIX Futures Term-Structure Index Excess Return

0.85% Note (Unsecured debt)

100% Long position in Mid-term (5 month maturity) VIX; 50% short position in Short-term VIX 

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