The VXX short term volatility etn rolls over contracts on an ongoing basis selling the near term futures as it nears expiration and buying the near one. As a consequence, when the volatility curve is steep indicating investors are nervous about long term volatility in the form of a sharp selloff even if the near term market is stable and moving upwards.
This has been the case with the VXX which has the strange characteristic of sharply increasing volume despite sharply declining price. This to me is a sign longer term professional investors are making use of the instruments since retail investors would have long ago sold out of an instrument with such large declines.
Barrons reports
These risk-avoiding hiding places include the obvious— high-grade bonds and gold—but also stretch to tactical asset allocation strategies and owning "volatility" as an asset class, through such things as futures on the CBOE Market Volatility Index, or VIX.
Zlotnikov pointed out a few months ago that investors "will go to great pains to avoid repeating the most recently made mistakes, but have few qualms about repeating mistakes from long ago. Today, this shows up as investors' extrapolating of the historically highest volatility" of 2008 into 2009.
Gordon Fowler Jr., CEO and chief investment officer at wealth manager Glenmede, made a similar point, suggesting last month that "protection against extreme outcomes…has become unprecedentedly expensive."
This is the muscle memory of the crisis still animating investor behavior. The iPath S&P 500 VIX Short-Term Futures exchange-traded note (ticker: VXX), which profits from rising volatility, has more than $1.4 billion in assets, despite having launched in January 2009 and the fund having lost almost 90% since inception. For more than a year, prices on the relatively newly tradable futures on the VIX—which measures the options market's implied forecast of stock index jumpiness—have shown a steep premium in more distant contracts. This means traders have consistently bet on a surge in market turmoil a month or three or six hence.
This market activity has made the medium term volatility etn far less painful in price declines, ytd the vxz is -10.7% and the vxx -69.7% (chart below) Athough should volatility in the markets heat up on a large stock decline the vxx will offer more leverage than the vxz in a positive direction as the hedge makes its impact/
Even at these numbers a small position in VXX would have not been devastating a position equal to 3% of a portfolio would have shaved 2.1% off overall portfolio performance. A 5% position which I would deem the upper limit in a portfolio would have knocked 3% off portfolio return. And a mix of 3% vxx and 2% vxz would drag down portfolio performance by a bit under 2.5%.
One analyst from Sanford Bernstein wonders whether the investors in the volatility etns are fighting the battles of past markets that may not be appropriate now.
Zlotnikov pointed out a few months ago that investors "will go to great pains to avoid repeating the most recently made mistakes, but have few qualms about repeating mistakes from long ago. Today, this shows up as investors' extrapolating of the historically highest volatility" of 2008 into 2009.
As one whose clients hold these instruments I would argue that the threat of a black swan is a constant in the market and a small position in these as part of a portfolio makes sense. I certainly have company a large number of volatility related etfs have come to market, a number of fund companies and hedge funds have established "black swan funds". And there is an effort which I applaud to construct a broader volatility/fear index than the VIX which is linked only to the S+P 500. The Barrons article notes:
Just last week, BofA Merrill Lynch introduced a Global Financial Stress Index, "a comprehensive, cross-market gauge of risk, hedging demand and investment flows. The index is designed to help investors identify market risks earlier and more accurately than commonly used risk indicators, such as the VIX index," according to its news release.
The index might well do just that, perhaps even better than well-established indicators such as the Bloomberg Financial Conditions Index. (It certainly does the job in back tests, of course.) Yet the fact that, to the research folks at the No. 2 U.S. brokerage house, this seemed a propitious time to initiate an early-warning system for financial upheaval says plenty about the mindset of investors.
With the uncertainties in Europe and potentially elsewhere a period of market turmoil certainly one as severe as this summer's Greek related decline is certainly a strong possibility , During that period the VXX increased over 90% and the vxz increased in value over 30%.Perhaps it is not the best time to give up on black swan hedging and maybe even a time to look like initiating such a position,
An interesting new ETN from UBS has a strategy for reducing the impact of contango by shorting 50% of the notional amoount in short term volatility futures and going long the medium term. Based on historical data (but not real world trading yet) shows the strategy merits investigation.
Advisor's clients hold positions in botb VXX and VXZ,
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