With the threat of further instability in the Eurozone, and the global ETP industry continuing to grow, should investors be taking advantage of using volatility as an asset class in its own right?
Measures of market volatility, such as the VIX (Chicago Board Options Exchange (CBOE) Volatility Index), otherwise known as the ‘fear index’ or ‘fear gauge’, have become important instruments for investors in measuring market sentiment. The VIX index attempts to discern the parameters that the value of the Standard & Poor's (S&P) 500 Index might fluctuate between over a 30 day period.
The relatively recent concept of establishing a long position in implied volatility as an equity hedge has appealed to some portfolio managers because of its inverse relationship with stock markets. Furthermore, using volatility as an asset class offers investors another form of diversification.
It is not possible to invest directly in VIX – ie spot VIX. As such, intricate exchange traded products including the market leading VXX (iPath S&P 500 VIX Short-Term Futures) launched by Barclays are aimed at market players who want to capitalise on movements of the VIX. An exchange traded note (ETN), the VXX is designed to track VIX futures. Barclays then purchases futures contracts on behalf of its investors, based on the CBOE index, rolling them over on a monthly basis.
Despite explosive interest in the VIX and related exchange traded products (ETPs), the finer points of volatility investing have left many investors stumped. In addition, using volatility as a hedge can turn out to be expensive. Ted Hood, CEO at Source recognises that volatility has piqued the market’s curiosity while also acknowledging the drawbacks. “We see escalating interest in volatility in today’s markets but the challenge is always the high cost.”
In normal market conditions, a long volatility investment will typically lose value. Consequently, the perfect opportunity presents itself for the large investment banks to design their own volatility products to address these ‘imperfections’. J.P. Morgan and Source have recently collaborated on one such project which has led to the launch of the JPM Macro Hedge US TR Index earlier this week.
The exchange traded fund (ETF) aims to deliver a two-pronged approach by capturing spikes during periods of volatility and promising favourable returns when conditions stabilise. Rui Fernandes, Head of Equity and Funds Derivatives Structuring at JPM outlines the objective of the new product, “Our Macro Hedge combines long volatility exposure with a transparent source of absolute return.”
The evolution of innovative volatility strategies and products in recent times has been swift. Interested investors should however tread with caution as these are sophisticated products that require a deep level of understanding.