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New volatility products help investors to hedge

Kathleen Brooks
EUROPE’s sovereign debt crisis has gained momentum this week after Greece’s debt was downgraded to junk status. Similar to the financial shock in 2008, this has rocked global stock indices and volatility has spiked higher in recent days.

Volatility indices, such as the Vix in the US and VSTOXX in Europe, measure the “fear” in the markets and they tend to react to big news with exaggerated moves. Volatility and stock markets are inversely correlated, so when the S&P 500 index fell by 3 per cent after Greece was downgraded on Tuesday, the Vix, which measures volatility on the S&P 500, rose by a massive 24 per cent, as did the VSTOXX index, which measures volatility on Germany’s Xetra stock index.

Any investors who were long volatility at the start of this week should be pleased with the profits they have made so far, and there could be more gains to come after Spain was downgraded yesterday. Volatility indices remain a way off from the peak they reached during the financial crisis when the VIX index jumped to a whopping 80, but in the event of a Greek default, or a break-up of the Eurozone, it’s not beyond the realm of possibility that volatility could again reach these highs.

As of this week investors’ ability to get exposure to volatility has got a lot easier. Barclays launched a set of exchange-traded-notes (ETN) on the London stock Exchange which allow investors to get exposure to volatility indices in Europe and the US. And it's timing could not have been better as investors look to hedge their portfolios from any further dips in the stock markets.

The investment community has broadly welcomed these new products. Mick Gilligan, a partner at Killick & Co, the stockbroker, says that volatility ETNs are a good addition to the range of exchange traded products now on offer: “They will be useful to have in the armoury, especially if you want to protect your portfolio without the hassle of owning futures or options.”

The chief concern investors have with owning futures and options on the volatility indices, which is another way to hedge risk, is that these instruments have finite lives. “If you buy an option to on the volatility index, because they expire on a certain date, every day the strike price of the option is below the market price then the time value of the option erodes,” says Christopher Wyllie, head of portfolio management at Iveagh, the private investment house.

In contrast, ETNs don’t have expiry dates so they don’t incur time decay. On top of this you don’t need to open a margin account as you do when trading futures, and your losses are capped to your initial investment only.

However, on the downside, the shape of the volatility futures curve can affect ETNs. For example, if you buy an ETN based on the Vix futures index it can lose value if the Vix market is in contango – when front month contracts are priced lower than forward month contracts. In this scenario ETNs lose some of their value every time the issuer rolls the Vix futures contract onto the next month. This phenomenon is known as negative roll yield.

“You can keep losing some of your money when the markets are in contango,” says Wyllie. “That happened during the financial crisis. ETNs are certainly not a free lunch, but the benefits need to be weighed up against the disadvantages.”

This is not the only risk for investors. Unlike ETFs, whereby the issuer holds theactual underlying, an ETN is collateral-free. This means that the issuer (such as the bank) makes up the gain or the loss incurred by the underlying index on a daily basis. Although this means that ETNs do not have any tracking error, its owner does have a credit risk exposure to the issuer, so if the issuer goes under then you could lose your entire investment.

Although Barclays is aiming these products at institutional investors as a tool to manage the risk in their portfolios, its ETNs have relatively small denominations – €25 for the VSTOXX and €100 for the Vix – which makes them accessible to retail investors.

While all other markets are headed south, volatility might be a more profitable investment until Europe’s debt crisis gets cleaned up.