By: Larry MacDonald

Mark Yamada, President & CEO of PŮR Investing Inc., designs portfolios of exchange-traded funds (ETFs) for investors. In my last post, I reviewed his use of  “risk budgeting” to rebalance portfolios with regard to the volatility of stock markets (a technique employed by the larger pension funds).

It’s an intriguing notion. Bear market bottoms have historically been marked by volatility spiking to certain levels, so when such readings arise, it may be advantageous to shift more aggressively into equities. Vice versa, when volatility descends to historically low levels for long stretches, the investor should be prepared to reduce exposure to equities.

In this post, I’d like to look at using a “VIX ETN” as another way to hedge against market downturns. It’s an approach Yamada is studying and may adopt.

In February, two exchange-traded notes (ETNs) began trading: iPath S&P 500 VIX Mid-Term Futures (VXZ) and iPath S&P 500 VIX Short-Term Futures (VXX). Both reflect movements in futures contracts trading on the CBOE Volatility Index (VIX), the “fear gauge that measures the level of anxiety in the market.

The basic idea would be to purchase an ETN as insurance when volatility declines to its lower boundary and is “cheap” and/or begins to climb and rises past certain thresholds. They would be sold when volatility crests and/or starts edging down again.

However, volatility investments are still a new concept for most investors and they need to be studied carefully before use. Indeed, several caveats should be mentioned right off the bat.

First, ETNs are the debt instruments of the issuers (usually large banks) and are thus subject to credit risk. They also have different tax treatment. For more details, see this Investopedia.com article.

Second, like commodity ETFs (as explained in a section to this Globe and Mail article), they may not track spot prices all that well: if VIX futures are in contango (contracts further from expiration have higher prices), the “negative roll yield” means that ETNs could decline even if actual volatility remains the same or rises slightly. But there should be some offset from the interest earned on Treasury bills put up as collateral for the futures.

Regarding the performance of VXX, Roger Nusbaum notes: “The short-term ETN fund has tracked closer to the underlying index (VIX) than the medium-term fund has … the VIX generally has a negative 0.66 correlation to the S&P 500, and the Short Term Futures ETN captures 40% to 50% of that effect.”

Both ETNs levy annual fees just under 0.9%. The short-term futures ETN is the more popular of the two, with over $200 million (U.S.) in assets. Trading volume is averaging more than 500,000 daily.

Actually, the tracking doesn’t look too bad thus far according to the Yahoo chart below. Over the past six months, as the market rebounded, the VIX has declined just over 40% while the VXX is down nearly the same.