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Inside the Volatility ETF Crash: Is a Rebound Coming?

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Despite a GDP contraction, extreme measures by the ECB, and just good (not great) jobs numbers, U.S. stocks continue to slowly march higher. In fact, the S&P 500 hovering around 1,950, putting the key American benchmark within striking distance of the psychologically important 2,000 level.

While this has been welcomed news for many equity investors—especially after the recent bout of turmoil—those that have made a bet on volatility in this time frame have been hit hard. After all, volatility levels have cratered, suggesting that many investors believe that smooth sailing is on the horizon, at least in the near term.

This poor trend is best represented by the most popular volatility exchange-traded product currently on the market, the iPath S&P 500 VIX Short-Term Futures ETN (VXX - Free Report) . This benchmark of volatility lost about 5% in Friday trading, capping off a horrendous week for the product in which it plunged by about 9.5% (see all the Volatility ETFs here).

Given this big plunge and some rockiness in the market, some might be looking for an uptick in volatility from these low levels. However, while a brief move higher is always possible, the longer term outlook for volatility investing is still pretty bleak.

Steep Curve

Arguably one of the most important factors to consider when investing in volatility is the futures curve. That is because products like VXX much roll their exposure from month to month and thus are subject to the forces of contango (upward sloping curve) and backwardation (downward or favorable sloping curve).

When there is a lot of contango in the market, it can create a roll hurdle that is tough to overcome for many volatility products. Unfortunately, this is pretty much the case for VXX right now, especially if you look at the current futures curve (read Don’t Let These ETFs Fool You).

Current futures are trading around the 12 mark, but ones later out, such as in September for example, are at around 15. This steady slope higher makes it very difficult for products like VXX as they must buy the more expensive contracts and then watch them (generally) go down in value to the spot level, and then must repeat this month after month.

Data Isn’t Helping

The only way to really break this trend is by giving investors a reason to be fearful. These events don’t really seem to be on the horizon though, leaving the market without a volatility catalyst.

This is especially true after the recent ECB decision which was very accommodative, as well as the bout of solid U.S. economic data. The jobs report and maufacturing data were particularly helpful on this front, suggesting that there might be smooth sailing ahead in the near term.

Other Volatility Products

Weakness in volatility has extended beyond the ultra-popular VXX though, as a variety of other volatility ETFs and ETNs have been hit hard. As you might guess, the 2x leverage products of (UVXY - Free Report) and (TVIX - Free Report) saw incredibly rough trading as these both saw losses approaching 10% for Friday, and nearly 20% for the last week (see Why I Hate Volatility ETFs And Why You Should Too).

Investors who have made a bet on inverse volatility though have been rewarded during this time frame, as these products tend to do well in a trending contangoed curve environment, much like what we see right now. In this corner of the market, investors have and (SVXY - Free Report) , two products which added roughly 5% on Friday, and have appreciated roughly 10% in the past week. And should these trends continue, these could definitely remain big winners in the broader volatility world.

Bottom Line

A short term pop in the volatility world is certainly within reason, especially if a weak data point hits or if there is earnings trouble on the horizon. However, the longer term picture for volatility investments is still pretty unfavorable.

The futures curve is heavy in contango which is a big deal for products that use futures and must roll from one contract to the next. Without a volatility catalyst, this can result in big losses even if volatility is generally flat for a time frame (read Volatility ETFs: 3 Factors Investors Must Know).

And given the lack of geopolitical issues out there as well as market moving events, we could definitely see volatility trend for a little bit longer. If this is the case, a short term bet on volatility might still work out, but a longer term play is still ill-advised; just because volatility ETFs and ETNs have fallen doesn’t mean they are due for a rebound, especially when the futures curve is against them.  

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