The fear gauge: a costly way to bet on rising risk

Twenty-five years ago, a Bob Dylan-loving finance professor called Robert Whaley moved to a tiny village in Burgundy, France, to spend six months “laying the groundwork for the finance industry’s most popular representation of terror”, says Robin Wigglesworth in the Financial Times. His creation became the Chicago Board Options Exchange Volatility index (Vix), sometimes described as
Wall Street’s “fear gauge”.      

At its simplest, the Vix is essentially a mathematical measure of how sharply investors expect markets to move, calculated based on the price of options on the S&P 500. However, the index has evolved from being a simple barometer of market conditions to being a complex multi-billion-dollar market in its own right. There is now an extensive range of financial derivatives based on the value of the Vix that are intended to allow investors to bet on rising or falling volatility, including exchange-traded products (ETPs) that are available to retail investors.

These ETPs, which first appeared in 2009, seem to offer investors an easy way to bet on an outbreak of stockmarket turbulence. Yet most of these products have an enormous structural flaw. They invest in Vix futures (derivatives that bet on how the value of the Vix will change in the months ahead) and because of how they are constructed must regularly sell futures that bet on what the Vix will be worth next month to buy ones betting on its value further ahead. Longer-term Vix futures are almost always more expensive than near-term ones, meaning that the ETP loses money every time it does this.

Over time, the losses mount. Had you invested $1m in the first Vix ETP in 2009, you’d have less than $600 left, Pravit Chintawongvanich of Macro Risk Advisors, a consultancy, tells the FT. The Vix’s creator is far from impressed by how his invention has been used by industry. In 2014, he told Barron’s that he is “shocked” and “appalled” by VIX ETPs.