Vix challenged by new volatility index

For 20 years, Chicago-based CBOE has marketed the Vix as the only volatility measure investors need. Across town, a tiny upstart is challenging this. Will its new index win over the world’s biggest banks? Yakob Peterseil reports

There is a bewildering array of volatility-linked products in existence, but virtually all of them have one thing in common: they are based on the Vix. Developed 20 years ago, the Vix index, known as the "investor fear gauge", measures investors' expectations of what stock market volatility will be in the near term. Not only is it the only volatility measure routinely quoted on the evening news, the Vix enjoys an effective monopoly on exchange-traded funds (ETFs) and exchange-traded notes (ETNs), finding its way into nearly every product out there. Some market participants are now trying to chip away at that.

Nations, a Chicago-based index provider, is rolling out options on a new index called VolDex, which it says gives a "purer" measure of implied volatility. "The volatility space needs more than just one player," says Scott Nations, the company's co-founder and president. VolDex uses fewer inputs than the Vix, which the company argues makes it friendlier for derivatives products. Nations' application to list options on VolDex has just wrapped up the public comment period, and the company says it is busy evaluating futures partners. The goal, says Nations, is to convince sponsors of ETFs and ETNs to use VolDex in their products.

The Chicago Board Options Exchange (CBOE) has taken notice. Unsurprisingly, the market leader is protecting its turf. CBOE, which developed the Vix, filed a comment letter with the US Securities and Exchange Commission in August arguing that Nations' application to list options on VolDex should be denied. Its position is that the application misstates certain technical details about the index. CBOE did not respond to a request for comment.

In the meantime, Barclays, JP Morgan and Société Générale (SG), banks that developed the first-generation of volatility products, have been hard at work rolling out ETFs and ETNs that promise to cut down on the inefficiencies that plagued earlier iterations and make volatility accessible to asset managers and buy-and-hold investors. Vast amounts of time and resources are therefore being invested into the Vix. Will banks that have already spent millions warm to a new benchmark that few have even heard of?

 

Because the spot Vix is impossible for traders to replicate, it becomes impossible for arbitrageurs to keep the levels of Vix futures consistent with the spot level of the Vix

'V' is for volatility

When it was introduced in 1993, the Vix immediately accomplished two things. First, it provided a reliable measure of expected short-term stock market volatility for investors. Second, the index could be used as a standard for derivatives instruments because it was based on a highly liquid underlying market: options on the S&P 100, which at the time accounted for 75% of index options traded in the US (the Vix methodology was later revised to be based on S&P 500 index options). Liquidity in the underlying market is important because wide bid/ask spreads can contribute to errors in readings; the more liquid the market, the narrower its spreads become.

Before the financial crisis, sophisticated investors had been using volatility to hedge or generate "carry" with over-the-counter instruments called variance swaps, explains Hichem Souli, London-based head of cross-asset pricing for Europe at SG. Firms that had built long positions in these swaps made a fortune during the crisis when volatility skyrocketed. But after copycats piled in and lost huge amounts, an alternative measure was sought - one that was transparent and liquid, two things that could not be said of OTC variance swaps. Enter the Vix.

Volume in Vix futures, which is how most derivatives products achieve their exposure to the index, quadrupled in 2010 and has more or less doubled every year since. It is not inconceivable that by the time the 2013 numbers come in, average daily volumes will have doubled again to $200 million of contracts every day - more than 40 times their level in 2009. The Vix is big business, and only getting bigger.

When the first volatility-linked ETFs and ETNs were rolled out to much fanfare by banks such as Barclays, Credit Suisse and JP Morgan, their shortcomings were immediately apparent. It is tremendously expensive to maintain a position in short-term futures on the Vix, investors realised. Between December 2005 and August 2011, the iPath S&P 500 Vix Short Term Futures ETN (VXX), a popular product, lost 0.18% of its value every day simply from maintaining its position, according to a Morningstar report. That, along with the systemic tendency of volatility to revert to a mean, contributed to eye-watering losses in the product. Through September of this year, VXX had shed an astounding 99% of its value.

Of course, that is only half the story, as market participants will tell you. "VXX is a product designed for more sophisticated investors to generally hold for short periods of time, based on their view of short-term volatility," says Ian Merrill, New York-based head of ETNs Americas at Barclays, which developed the product. In other words, VXX is appropriate to hold for days, not years. Still, bad publicity attached to it and haunts it to this day, though that has not prevented it from attracting $1.49 billion from investors.

Another shortcoming became evident when investors would try to reconcile the levels of their products with the spot, or current, levels of the Vix. A quirk of the Vix ensures that these values will always be different. Because the Vix itself is not a tradable asset, its futures have a tendency to get out of whack. "Because the spot Vix is impossible for traders to replicate, it becomes impossible for arbitrageurs to keep the levels of Vix futures consistent with the spot level of the Vix," says Nations. This can create a considerable gap between where Vix futures might be expected to be and where they actually are. The suggestion is that derivatives on the Vix are, at best, a spotty reflection of where the actual index level stands.

Further, and most damningly, Nations argues that the Vix does not even measure what it purports to. "Option skew muddies the information delivered by the Vix," he says. Skew refers to the measure of the difference in implied volatility between options having the same expiration date but different strike prices. It creeps in to the Vix because of the way the index methodology is constructed. Skew is a useful measure, but is distinct from implied volatility. Vix defenders say it has its place in recording investor uncertainty, but it is not, strictly speaking, implied volatility.

VolDex does away with skew, thus rendering an arguably purer reading of implied volatility, Nations argues. And because the index uses a closed universe of at-the-money options on SPY, an ETF tracking the S&P 500 index, Nations argues that it will make a far better reference for derivatives products. "The Vix is made up of hundreds of options that change by the second. But VolDex uses only at-the-money options. If VolDex futures stray from the cash index value, it will be easier for arbitrageurs to enter the market and keep the two values more closely connected than is possible with the Vix. In other words, the band by which VolDex futures can stray from the cash VolDex should be smaller than the existing band for Vix products," says Nations.

Market participants that have reviewed VolDex acknowledge this strength. "I can certainly see a benefit in terms of replicating [VolDex] with low costs," says a London-based equity derivatives strategist at a European bank. "If you are an ETF provider looking to replicate the volatility of the S&P 500, VolDex is probably a good choice," says Gordon Rose, Frankfurt-based fund analyst at Morningstar.

 

Uphill struggle

Still, Nations will have to get the attention of the major players in the space first. Banks such as Barclays and JP Morgan have been hard at work improving the first-generation Vix-linked products. Barclays was an early mover, launching ETNs like the iPath S&P 500 Dynamic Vix (XVZ) and the S&P 500 Dynamic VEQTOR ETN (VQT), which combines exposure to short-term Vix futures with the S&P 500. The innovation lies in reducing some of the inefficiencies that made earlier products unappealing to longer-term horizon investors. "We tried to deliver products for asset allocators who are looking for something they can hold for many months, or even years. We wanted them to think of it as a more stable piece of their portfolio," says Natalia Bandera, director, equities and fund structured markets at Barclays in New York. VQT has attracted $585 million from investors, while XVZ has gained $170 million.

In Europe, another traditional powerhouse in the space has been following a similar strategy. Three years ago, JP Morgan launched its suite of Macro Hedge indexes, which it diversified last year into London Stock Exchange-listed ETFs. The objective of these strategies, says Arnaud Jobert, London-based executive director in equity derivatives structuring, is to provide long-term US volatility exposure while minimizing the cost of holding the position. This is comforting to longer-term investors. The flagship Macro Hedge US TR ETF has gathered $213 million in AUM. Pensions, insurance companies, family office clients and asset managers are clients - hardly the in-and-out traders for which products like VXX were created.

Aside from VolDex, NYSE Arca is rumoured to be developing an alternative volatility product, though the exchange would not confirm it. And in Europe, the Eurex exchange is set to roll out listed variance futures, a popular pre-financial crisis volatility play (they have already been rolled out on CBOE, to limited success). And Vstoxx, a Vix-like measure that tracks the volatility of the Euro Stoxx 50 index, has been gaining ground, banks say, as the correlation between US and European equity markets falls.

But the struggle for VolDex to win market share will be an uphill one, not least because the biggest players continue to see value in the Vix. "I think the Vix will probably remain the main gauge for people to assess volatility. It will remain the benchmark, in my view," says Jobert. "It is the most liquid and the most transparent," agrees SG's Souli. "We know the index providers are out there trying to figure out the next best thing. But the toolkit of volatility offerings we have now is what most of our clients want when they want to express different equity market views," says Barclays' Merrill.

According to Morningstar, from 2008 to 2012, the Vix moved in a different direction from the S&P 500 72% of the time. That makes it the finest equity hedge yet to have been discovered and successfully marketed to investors. "Our research team has done a study and found that the two assets that are almost always uncorrelated with equities are credit default swaps (CDSs) and volatility," says one London-based banker. CDSs cannot be traded easily, so the Vix became the obvious choice for the banks. The shortcomings of the Vix are largely beside the point, he suggests. "From a market point of view, all people care about is having an instrument to use as a hedge," he says. "If tomorrow, they find another asset that is as uncorrelated to their portfolio as the Vix, they will invest in it."

This is a glimmer of hope for VolDex. There is nothing, it seems, keeping banks wedded to the Vix should a liquid and widely followed alternative come along.