Rethinking VXX as an Equities Hedge
I don’t like this play when VIX futures are contangoed, which they usually are (and are right now), because the futures term-structure is working against VXX a little bit each day like a dripping faucet.
In over-simplified terms, when the market goes up or down, the hedge will mostly do its job, but when the market goes sideways, the VIX futures term-structure acts as a drag on the portfolio.
Another approach is to flip that trade on its head: go long XIV (the daily inverse of VXX) and hedge with a short equities position (short individual stocks, long SH, etc.)
Now, you’re getting exposure to the “market” (because of the high correlation between the VIX and equities), plus the benefit of contangoed VIX futures (i.e. the faucet drips in your favor), and a reasonably tight beta hedge.
When VIX futures move to backwardation, the trade is then flipped back to what most folks are doing today: long equities + long VXX.
This approach isn’t without its own drawbacks. The two biggest are:
First, the relationship between volatility ETFs and stocks is not perfectly correlated and not static, meaning the hedge won’t always do exactly what we think it’s going to do. But that’s also true for the popular equities + VXX trade, so this isn’t a new problem.
Second, and much more importantly, should volatility suddenly explode (i.e. the market crashes), the losses (gains) in XIV (VXX) will likely accelerate faster than the market, relative to norms.
Oversimplifying things (a lot), imagine that in a “normal” market, the daily move in XIV is 5x the change in the S&P 500. In a market crises, maybe that number jumps to 8x or 10x (warning: totally made up numbers).
That means, to stay well hedged to market crashes, you must carry less exposure to market beta, and rely more on contango for returns.
With the popular equities + VXX trade, you can carry a smaller hedge, and still maintain a lot of exposure to market beta, because that acceleration works in your favor during a market crash.
That’s an important difference.
The popular approach, long equities + long VXX, is a more beta-centric trade. The investor (a) can carry more beta, and (b) relies more on beta to generate returns.
My proposed trade, long XIV + short equities, is a less beta-centric trade. The investor (a) must carry less beta, and (b) relies more on the VIX futures term-structure to generate returns.
Regardless of which approach is “better”, I wouldn’t discount the fact that the popular equities + VXX approach is probably easier on most investors’ psyches. Most investors like beta, even if they don’t realize it.
. . . . .
Filed under: VIX & Volatility | 8 Comments