When markets bob, you can bet on the fear

Fear of the future – and whether it will bring recession, inflation, or deflation – seems to be prompting some investors to seek insurance in the form of products that can produce a payout if a “fat tail” event comes along and knocks us all for six.

In reality, I don’t think products as simple as that really exist. After all, if anyone were able to devise one – for example, a deep, long-dated, out-of-the- money put option – they’d find themselves so over-whelmed with demand that pricing would go ballistic.

So, instead, investors have had to focus on halfway house products: asset classes or structures that generally move in the right way if all hell breaks loose. Of these, volatility- based products are proving especially popular.

Barclay Capital’s return to index tracking products – after its sale of iShares to Blackrock – is being led by structures that pay out based on stock market volatility (see www.ipathetn.com).

These products are actually exchange traded notes (ETNs) – effectively a form of structured IOU. You hand your money over to BarCap, which promises to pay a return in line with an index measuring the volatility of the S&P 500 (called the S&P 500 Vix) or the EuroStoxx 50 (called the VSXX). That IOU, by definition, carries counterparty risk – BarCap going bust – and the structure means that you’re not buying a basket of actual assets. In fact, in the case of the popular US measure of volatility – the CBOE Vix index – you can’t buy the index at all as it doesn’t allow any profit or loss. BarCap’s ETNs are actually something called implied variance swaps. If it sounds complicated, that’s because it is.

iPath currently markets two forms of these trackers: one using short-term variance in the S&P 500 Vix or VSXX and one that tracks the mid-term variance. Looking at historical data from these indices, the very rough rule is that the mid-term measure returns between 25 per cent and 50 per cent of the short-term measure – ie, volatility measured over the shorter term is higher. Source ETF also has a new fund that tracks the S&P 500 Vix Short-Term Futures Total Return Index. It has been structured as a Ucits III-compliant exchange-traded fund (ETF), listed on the London Stock Exchange, with an annual charge of 0.6 per cent.

With all these products, the basic idea is that, as markets fear levels rise, so too do the volatility indices. Therefore, by investing in a volatility tracker ETN or ETF, you should make money whenever share prices become more volatile.

Sadly, though, there are some caveats – so many, in fact, that I reckon these products should only be used by very adventurous or experienced investors.

First, looking at past data for the S&P 500 Vix, there appears to be no simple straight line relationship between falling markets and increasing volatility. In general, as share prices fall, volatility does rise, but not predictably. There is every reason to think that as markets change and evolve these relationships could change again.

Second, these volatility trackers are investing in futures contracts, and, as these contracts roll forward, guess what happens? You lose! Think about it – if you’re an options trader and you’re being asked by a fund manager to write a futures contract to protect against the possibility of increased volatility, you’ll make a charge. And as the demand for that “protection” increases, you’ll put your charges up.

If markets are ultra-bullish, the cost of that futures protection will start off very low. But, sadly, we’re not in a bullish phase and everyone wants to protect themselves. So the “carry” cost on the short-term futures contract is close to 10 per cent per month and on the mid-term futures contract it’s 5 per cent per month. If you sit tight and hold these products for months, that carry cost will destroy your investment even if volatility does rise. For this reason, these products are really for short-term traders who will get in and out jolly quickly.

But I’d add one last caveat: the real money to be made on these volatility products is when the gap between actual volatility and projections of future volatility is very wide. In other words, in those complacent bullish phases where futures pricing is very low but actual volatility is moving up as a steady trickle of bad news unsettles the market. The catch-up that occurs in futures pricing can give investors a double bonus. Unfortunately, I don’t think we’re in a world where absolute complacency rules. I accept that the Vix could go higher – but, even at heightened levels, the carry cost could take away most of your gain if you sit too long in a volatility tracker.

adventurous@ft.com