Volatility in the stock market is represented by the CBOE Volatility Index (VIX), also known as fear gauge. This tends to outperform when markets are falling or fear levels over the future are high. None of these has happened lately.
As such, VIX plunged to the lowest level since 1993 last week, reflecting no fear or a greater complacency in the stock market. The index has traded below 10 for most of this year, less than half its historical average of around 20. It has posted 27 closes below 10 so far, with more than 70% of its finishes at that level.
VIX to Trend Lower
The Wall Street continued to scale new highs, dodging all economic and political ills and indicating that the second-largest bull run still has legs. The gains were broad based across all market spectrums and sectors (read: Leveraged ETFs to Play the Second-Largest Bull Market).
The trend is likely to continue given rounds of upbeat economic indicators, strong expectation for the Q3 earnings season, improving health of economies around the world, stabilizing oil price, and enthusiasm over tax reform. Additionally, the Fed’s hawkish stance signals a strengthening economy, which will fuel growth in the stock market. Apart from these, Treasury yields are on rise as the 2-year Treasury yield hit the highest level since 2008 and the 10-year yield touched a three-month high. All these factors might keep fear levels down, pushing the volatility index even lower.
Further, after diverging in the past couple of months, the Dow Jones Transportation Average has caught up with the rally in the Dow Jones Industrial Average, indicating continued bullishness as we head into the fourth quarter. According to the century-old Dow Theory, any long-lasting rally in Dow Jones Industrial should be accompanied by a rally in Dow Jones Transportation. This suggests that more pain in store for the volatility index.
If this wasn’t enough, per Sam Stovall, chief investment strategist at CFRA, when the S&P 500 gains in August and September, often the worst months of the year, it typically rallies through the end of the fourth quarter for a 2% average gain. Moreover, history also tells that the fourth quarter has often been kind to equities with the holiday months of November and December, when spending picks up. Attesting to the stock market strength is long-time bull finance professor, Jeremy Siegel’s expectation that stocks will rally 10% in the last 101 days of the year courtesy of the Trump effect, especially tax reforms. The bullish outlook indicates that the volatility index will crash further (read: 5 Winning ETF Strategies for Q4).
Inverse Volatility ETFs in Focus
Given this, investors should bet against volatility with the following inverse ETFs. While there are eight inverse volatility ETFs currently on the market, three have gained immense popularity and have more than doubled this year. Below, we have highlighted them in detail:
REX VolMAXX Short VIX Weekly Futures Strategy ETF
This ETF seeks to gain when volatility falls as it provides short exposure to the VIX Index by holding a combination of VIX futures contracts that are near expiration. It does not seek to track the performance of the VIX Index or the S&P 500 and can be expected to perform differently from the VIX Index over any time period. It targets a weighted average of time to expiry of the VIX futures contracts that is less than one month at all times. Since VMIN is actively managed, it charges a higher expense ratio of 1.45%. It has a lower level of $17.9 million in AUM and trades in average daily volume of 36,000 shares. The product surged 130% this year (see: all the Inverse Volatility ETFs).
VelocityShares Daily Inverse VIX Short-Term ETN
With AUM of $1 billion, this ETN offers inverse exposure to the S&P 500 VIX Short-Term Futures Index, which reflects implied volatility of the S&P 500 Index at various points along the volatility forward curve. It charges a higher expense ratio of 1.35% but trades in heavy average daily volume of 12.3 million shares. The note has gained 115.6% year-to-date time frame.
ProShares Short VIX Short-Term Futures ETF (SVXY - Free Report)
Like XIV, this fund also offers inverse exposure to the S&P 500 VIX Short-Term Futures Index. It charges relatively lower 95 bps in annual fees per year from investors and trades in average daily volume of 6.5 million shares on average. The fund has accumulated $953.4 million in its asset base and is up 113.1% so far this year.
State of Contango: A Win for These ETFs
Investors should note that the ETF tracks the futures market and not the spot price of VIX. Therefore, it has to roll the contracts to maintain a notional exposure of time to expiration of less than one month. Hence, the fund is susceptible to roll yield.
Generally, roll yield is positive for the VIX index when the futures market is in backwardation and negative when the futures market is in contango. The VIX futures market is perpetually in a state of contango, a situation where near-term futures are cheaper than later-dated futures contracts. So, the index is selling low and buying high each time it rolls over its contract. This has led to the underperformance of the VIX futures index-based funds (read: The Key Things to Know When Trading Volatility with ETFs).
However, the case is opposite for inverse volatility products. Since the ETF capitalizes on rolling short VIX futures contracts, it is benefiting from a state of contango in the futures market.
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