What is Volatility?
While most investors look at whether the stock market is going up or down, an equally important market indicator is the volatility of the market overall. Higher volatility generally means a less stable market, while lower volatility usually means a more stable market. While this is not always the case, investors generally assess a market’s health by looking at how volatile it is.
More specifically, volatility refers to the potential of a security or market to go up or down. More volatile equities will go up (or down) more quickly, and much higher (or lower) than less volatile equities in the same period of time. As a general rule, some asset classes are more volatile than others. Large-cap stocks tend to have less volatility than mid-cap and small-cap stocks.
Volatility can be measured in a variety of ways. Since it is a relative performance metric, the volatility of a stock is usually measured relative to a larger market index or financial instrument. The S&P 500 is perhaps the most popular metric for assessing the volatility of an individual stock.
To measure a stock’s volatility relative to the S&P 500, investors will track how much the prices for both the stock and index move in a certain period of time. If the stock has moved 120% and the index has moved 100%, the stock has a beta of 1.2—meaning it is 1.2x more volatile than the index. Likewise, a stock that has a beta of 0.9 has moved 90% every time the index has moved 100%.
What is the VIX?
Because it is impossible for one person to calculate the volatility of each stock and index on the market, portfolio managers will look at volatility indexes to assess the overall volatility of a market.
To assess the volatility of the S&P 500, the Chicago Board Options Exchange introduced their Market Volatility Index, or VIX. This index tracked the prices of options for the S&P 500, which should indicate how much volatility that investors expect in the market. While this measurement is subjective and has been criticized as inaccurate, it is the most widely used measurement of market volatility in the United States.
Volatility ETFs
One cannot buy shares in the VIX, since it is merely a measurement of potential volatility and not a company or fund. However, there has been an increasing demand for an asset that investors can buy which tracks changes in the VIX, partly because it rises and falls so frequently, and partly because several investors want the option to bet on the economy as a whole. Many investors also see a bet on the VIX as a way to hedge their stock holdings in case higher volatility causes a fall in stock value.
Actually producing a VIX ETF that reliably tracks the index is easier said than done. Several new products have been released in the ETF market with promises of tracking the VIX, but it remains to be seen if any succeeds in their mandate.
The longest-running and most popular VIX ETF is the iPath S&P 500 VIX Short Term Futures ETN (VXX), which was created only in January 2009 and is managed by Barclays. The fact that this ETF is less than four years old demonstrates just how new and untested the volatility ETF market is.
The VXX aimed to track the VIX by investing in equity futures, but it has fallen steadily since inception–except for a brief spike in mid-2011. While the VIX has also fallen to record lows in 2012 and fallen steadily since the inception of VXX, the VXX has actually fallen much lower than the VIX it aims to track.
ETF Dangers and Past Performance
This is partly because the VXX uses leverage—a necessity to invest in the futures market, but also a cause of problems for ETFs, because it often results in a decay of the value of the ETF and a resulting divergence from the underlying index that is being tracked. VXX recently saw a 4-1 reverse split after two years of declining value, but it has received net inflows of over $3 billion in 2012 and is one of the best-selling ETFs of 2012, partly because there is pent up demand for a product that tracks the VIX.
The fall in VXX’s value is a result not only of fall in the VIX itself, but in contango, a phenomenon in futures trading that causes spot prices to fall for a futures contract. Inherent inefficiencies in the futures market like contango, combined with the decay of a leveraged ETF, has caused VXX to be a dangerous fund to invest in, and these may remain issues for future ETFs in the space. While volatility ETFs remain an option to invest in volatilty directly, they remain inefficient and subject to a loss in value above and beyond changes in the underlying volatility index.