PORTFOLIO POINT: This ASX product offers leveraged exposure to the movements of a range of assets, but it's more suitable as a short-term hedge.
“Trader talk” news segments last week were dominated by surging levels of market volatility, as reflected by the big jumps taken in the VIX index.
This once arcane concept has become part of the general lexicon since the GFC, when it became a shorthand way of telling what was happening in the underlying markets. Although the concept of volatility is technically simply a measure of the pace at which (and by how much) asset prices are moving, the old adage that markets go up by the stairs and down by the elevator means that spiking volatility is a sign that markets are falling.
As most investors know by now, when the VIX index rises very quickly, this coincides with sharp and rapid falls in the market – exactly like we are seeing now as the euro crisis blossoms into what may become the GFC part 2. So for an investor exposed to falling asset prices, being able to buy protection against rising volatility levels should be an effective way to protect against capital losses, and the new RBS “VIX” MINIS offer the potential to do just that.
The (main) VIX index is a futures contract traded on the Chicago Board of Exchange, in respect of movements in the volatility of the S&P 500 index – e.g. the broad US stockmarket index. Other international indices have their own VIX index, but the S&P 500 is the most liquid. Volatility is a measure of both the size and rapidity of the movements in an asset price; and so the S&P 500 VIX index relates to the world’s largest sharemarket – which is still one of the major drivers of sentiment and performance in regional stockmarkets, such as the ASX.
Looking at volatility movements in previous market downturns shows that rising volatility is often a leading indicator of negative market movements. For example, volatility rose significantly in the week prior to the October 1987 stockmarket crash, so using the VIX as an indicator of market movements can often be a good guide to forthcoming market activity.
The CBOE VIX Index is a highly sophisticated market, dominated by hedge funds and professional traders. Rather than reflecting actual volatility in the underlying market (e.g. the S&P 500), the CBOE VIX Index reflects what participants expect to be the future volatility. Nevertheless, subject to the qualifications below, it can still be used as a useful tool to manage volatility and portfolio risk. That is because a spike in volatility today will be directly reflected in a rise in the levels of the VIX index, and a perception of falling volatility will also be translated into falls in the VIX index.
Investing in the CBOE VIX Index futures pays off with reference to changes in its levels during the investment term. For example, buying a VIX index futures contract will generate profit for the investor when the VIX index rises during the investment term, whereas selling a VIX index futures contract will trigger a loss for the seller if the VIX index rises during the term of investment.
Enter the RBS VIX MINIS. As we have previously shown in Eureka Investment Road Tests, MINIS are a relatively simple ASX product that involve leveraged exposure to the movements in a range of assets. Each MINI relates to a specific asset (share, index, or commodity) and can be purchased as a “long” or “short” MINI. RBS was a pioneer of the Australian MINIS market and, to date, is the only provider of VIX MINIS.
MINIS involve leverage, because the total cost of the underlying investment is broken down, inside a MINI, into the investor’s capital cost and the balance which is provided through finance provided by the issuer of the MINI (think of this like vendor finance – the investor doesn’t directly borrow from the issuer but benefits from the leverage). In MINI parlance, the amount that is financed by the issuer is known as the “strike price” and this is the amount that has to be paid by the investor when and if they choose to “exercise” the MINI. MINIS are created and traded on the ASX under its warrant market rules; although they are not derivatives, they do contain some of the aspects of warrants (e.g. a “strike price”), which investors may be familiar with.
The main reason that MINIS aren’t typical derivatives is that they don’t have a maturity date – and hence (unlike traditional derivatives) they don’t suffer from time decay (e.g. the process whereby an option contract loses value as it approaches maturity). As a result, MINIS are often simpler to understand and manage than other forms of retail warrant or structured products.
The issuer of the MINI protects the value of the finance it has provided to create the MINI (embedded in the cost of the MINI and measured by the “strike price”) by including a “stop loss” mechanism in the MINI itself. This operates such that, if the price of the underlying asset falls to within 10% of the value of the internal finance/strike price, the issuer will be able to sell the asset and use the funds realised to pay down the finance. The investor will receive any excess of that sale price. Obviously this mechanism resembles some of the more pernicious aspects of old style margin lending (without the personal liability to repay the loan), and can expose the investor to a significant risk of loss of capital when markets fall dramatically. In practice, the risk for a MINI investor can be reduced to acceptable levels by selecting low levels of leverage ( e.g. a strike price which is well below current asset prices) and investing in assets with low levels of price volatility.
The problem for potential investors in the RBS VIX MINIS is that, lo and behold, the VIX index itself is highly volatile. Last week, for example, the VIX index jumped from 15% to 24% overnight – a rise of nearly 60% in one day. Similar levels of movement are often seen on the way down, too, such that a VIX MINI can easily suffer the fate of a stop-loss-induced sale of the underlying asset (the VIX futures contract).
It’s for these reasons that RBS VIX MINIS are typically suitable only for sophisticated investors and day traders – investors who are capable of selecting suitable strike prices and timing the decision to buy and sell. Holding VIX MINIS for extended periods is not seen as a suitable method of hedging the portfolio, because of the prospect of large moves in the value of the VIX index and the related likelihood of being stopped out.
The other problem for potential investors relates to the use of the CBOE VIX futures contract as the reference asset. This is a liquid and widely-invested index, but because it references the monthly VIX futures, it imposes “rolling” risk onto investors. That is, when markets expect the value of an asset to be higher in the future than it is today, the futures contract will trade at higher levels than the current “spot” price of the asset itself. When this happens, the futures contract is known as being in “contango”, whereas a lower expected future value will mean that the contract is in “backwardation.” Right now, the VIX index futures are steeply in contango, and the additional cost of rolling into new month’s futures contracts is added to the internal leverage within the MINI – and is reflected in a rising strike price over time.
In summary, because of the high volatility of the VIX index futures, and the steep contango (which forces the strike price to rise over time), the RBS VIX MINIS may not be suitable for medium to long-term hedging. Since volatility does perform as a leading indicator of sharemarket moves, the RBS VIX MINIS may nevertheless be suitable and attractive as a short-term hedge against the potential for capital losses in the event of ongoing deterioration in global sharemarkets.
The score: RBS VIX MINIS – 3.5 stars
0.5 Ease of understanding
0.5 Suitability of underlying asset
1.0 Regulatory risk