All Investors Are Long Volatility, But Theres Help

This article is part of a regular series of thought leadership pieces from some of the more
influential ETF strategists in the money management industry. Today's article is by Mike
Venuto, co-founder and chief investment officer of New York-based Toroso Investments.
Over the past few years, there has been a lot of discussion about volatility as an asset class. The
recent turmoil in the market has reignited this debate.
In my opinion, volatility is not an asset class; rather, its a market factor that all investors are
inherently long. Factors are idiosyncratic risk that traditional index investors inadvertently
accept. Assets are tangible; they can grow and compound value.
Volatility is a behavioral result or return characteristic, and usually a bad one. Unless an
investor explicitly limits volatility, they are long this factor. The advent of VIX exchangedtraded products (ETPs) was intended to provide investors the ability to mitigate the exposure
to this factor.
The unintended consequence of these innovations was to create an opportunity for astute
investors to profit from others desire to purchase volatility insurance.
What Volatility Really Is
Before delving into the intricacies of these ETPs, lets clearly define the volatility factor.
Realized volatility is simply a measure of standard deviation or investment performance
outside of historical norms.
Since the market trends upward, most spikes in volatility usually correspond with negative
economic events. Additionally, realized volatility erodes the positive effects of compounding
returns.
This is best illustrated by Jeremy Siegels volatility paradox, which notes that returns are not
geometrically offsetting. A loss of 10 percent in value requires a gain of 11 percent to go back
to the original value. Volatility exponentially amplifies the breakeven requirements; a loss of
25 percent needs a 33 percent positive return to reset. Clearly mitigating this factor can have a
positive effect on portfolio performance.
Historically, investors have attempted to limit volatility through diversification and asset
allocation. Over long market cycles, this has worked, but in times of extreme stresslike 2008,
or most recently, during August of this yearcorrelation of investments increases and the
negative impact of volatility trumps the benefits of diversification.
The Need For Short-Term Tools
Investors with shorter time horizons need tools that implicitly mitigate the volatility factor;
hence, the advent of volatility ETPs.

Most volatility ETPs seek exposure to the VIX index. The VIX index is a measure of implied
volatility, which calculates the anticipated future standard deviation of the S&P 500 based on
options prices. The VIX index is unique in that it does not compound, and always mean-reverts.
Unlike an asset, it cannot go to zero, and it cannot go to infinity. Historically, the realized
standard deviation of the S&P 500 has been about 16 percent. Over the past 20 years, the
average value of the VIX has been about 18, indicating an anticipated volatility or implied
volatility of 18 percent. It is common that implied volatility is higher than realized, and this
spread is translated into the cost of purchasing insurance on realized volatility.
Most ETPs that offer exposure to the VIX do so using futures. Essentially the underlying
indexes combine long and/or short allocations of at least two VIX futures contracts.
Youre Not Buying Spot VIX
The process is complicated, but the most important thing for investors to understand is that
investing in VIX futures will not result in returns that correspond identically to the VIX spot
price.
This phenomenon is best illustrated by the first VIX futures-based ETN. The iPath S&P 500
VIX ST Futures ETN (VXX | B-62) launched in January 2009, at a time when spot VIX was
relatively high, around 44. Today spot VIX is about 45 percent lower, but VXX is 99 percent
lower. It is safe to say that VXX is not a buy-and-hold investment. This is due in large part to
the cost of maintaining the exposure or insurance.
Since the launch of VXX in 2009, I have been fascinated by volatility ETPs. A key component
of my investment philosophy is the acknowledgment that problems and inefficiencies create
opportunities. This is an aspect shared by well-known investment managers in the ETP
industry.
When Inverse Is Not Shorting
Greg King, currently CEO of the newly created REX ETFs, was both one of the architects of
VXX and the creator of the vehicle, which captured the opportunity created by its inefficiency.
In late 2010, King, via VelocityShares, launched the VelocityShares Daily Inverse VIX ST
ETN (XIV), which represents the inverse of the VIX Futures index tracked by VXX. It is
extremely important for investors to understand that XIV is not short the VIX; it is short the
cost of using futures to gain exposure to the VIX.
In other words, XIV collects and compounds the cost or premium others are willing to pay for
insurance. That said, when volatility spikes, the cost structure or futures curve inverts, and XIV
loses significant value quickly and violently.
The metaphor of picking up pennies in front of a steamroller accurately describes investing in
XIV, but instead of pennies, investors collect dollars. I believe harvesting those dollars and
consistently rebalancing exposure to XIV is one way to avoid being crushed.

A less popular way to express this trade or metaphor is to pick up quarters in front of a go-kart
with the VelocityShares Daily Inverse VIX MT ETN (ZIV). ZIV investors can still get hurt,
but not likely crushed, and the insurance premium collected is much smaller.
ZIV tracks the inverse of the midterm VIX futures index. It collects the cost of maintaining
exposure to VIX futures by using the three- to seven-months futures. This part of the curve is
less expensive and less reactive to moves in the VIX. Since inception in 2010, ZIV is up about
180 percent.
The Volatility ETP Universe
Today there are close to $5 billion allocated to ETPs that invest in VIX futures. There are about
equal amounts dedicated to products that are long VIX futures as there are to the inverse
products. There is also about $1 billion in a new suite of products that dynamically move from
equity exposures to long or short VIX futures.
ETPs
Long VIX Futures
Leveraged Long VIX Futures
Short VIX Futures
Equities + L/S VIX Futures
Total:

Assets $M
$1,176,613.90
$730,168.10
$1,992,688.50
$1,057,104.10
$4,956,574.60

# of ETFs
3
1
1
4
9

# of ETNs
4
2
4
3
13

It should be self-evident that current VIX futures-based ETPs are insufficient tools to mitigate
the realized volatility factor in a portfolio unless an investor has impeccable and consistent
timing.
That said, innovative new products are launched every year. Perhaps one of the most interesting
launches in this space was this years AccuShares Spot CBOE VIX Up Shares (VXUP) and
AccuShares Spot CBOE VIX Down Shares (VXDN).
These ETFs seek exposure to spot VIX, which is the holy grail of volatility-factor reduction.
Unfortunately, this is not easily achieved, and the structure of these ETFs appears quite
convoluted at first glance.
They own cash instead of futures. Their value is maintained through distributions. There are
equal amounts of VXUP and VXDN shares: Once a month, a distribution is made from one to
the other that corresponds to the relative percent change in the VIX. This distribution is
intended to keep the ETFs trading close to their stated net asset value (NAV).
Circuit Breakers Built In
Theoretically, the insurance premium inherent in VIX futures implies that there should always
be more demand for VXUP than VXDN; therefore, VXUP should normally trade at a premium.
AccuShares was acutely aware of this possibility, and built circuit breakersor triggersinto
the structure that force a series of special distributions if either fund trades at significant
premium or discount to NAV for more than three consecutive days.

Around Aug. 17, this structure was tested when the VIX spiked more than 200 percent. To my
surprise, VXUP was trading at about a 35 percent discount to NAV at this time of extreme fear.
On Aug. 24, the special distribution process successfully brought the trading price back in line
with NAV. Only time will tell if investors embrace this concept now that these ETFs have
passed the first test.
So, if you are investing in the stock market, you are idiosyncratically long volatility.
There are many new and innovative ETPs to help mitigate that factor, but the intricacies and
execution of these products requires vast knowledge of their structure and pricing.
When investing, I prefer to embrace the volatility factor, if properly compensated and hedged.
After all, Warren Buffett didnt become rich by buying insurance; instead, his success came
from prudently selling insurance. It might be time for ordinary investors to benefit from selling
insurance as well.