VSXX Disappoints European Investors

I have written before about VSXX - an ETF that tracks pan-european VSTOXX volatility index, European equivalent of VXX. In that post I described how VSXX performance may be different, because of the flatter term structure of VSTOXX volatility futures, that will translate into lower rolling costs, and better performance for VSXX investors, at least compared with VXX. I also noted that traders may take advantage of this difference in a relative value trade. When I wrote the post, VSXX was trading for only two months, however now after seven month of trading it is becoming clear that my investment hypothesis not deliver, and VSTOXX futures markets became more economically efficient.

Here's the chart of what happened: VSXX originally listed at around the same Euro value as the index, however in the last few weeks VSXX is about 70% of VSTOXX index.



If you looked at the relative plots of VIX and VSTOXX with their futures indexes (on which ETFs are based) it is clear that historically VSTOXX futures index did much better job in tracking index levels than the VIX futures index. To understand the dynamics, I have performed the following two regressions:

return on SPVIXSTR ~ α + β * return on VIX, and
return on VST1MT ~ α + β * return on VSTOXX.

Using the data for the last five years, in the first case α = -0.0016174 (t=-3.2335) α * 252 = -40% per year negative "premium" for the VIX futures index. In the second case α = -0.00021095 (t= -0.30876, intercept not statistically significant) α * 252 = -5% per year negative "premium" for the VSTOXX futures index.

However when I used data for the last half year - approximately since VSXX came into existence, intercept values became much closer to each other, at -0.006422 -0.0047229 for VIX and VSTOXX respectively. These numbers by themselves imply a very negative risk premium, they are at least the same order of magnitude, as opposed to alphas from the 5-year regressions.

It seems that there is an equal demand now in Europe for volatility protection, which brought returns on the futures indexes in line with each other. In fact VSXX and VXX followed very similar paths (normalized returns in local currencies)

In conclusion: what was hoped to be a unique investment opportunity for European investors seized to exist. Once a trading instrument is in the market traders work quickly to make profits and eliminate inefficiencies.

VSXX - VSTOXX ETF Performance Very Different From VXX

Edit Dec 7, 2010: See my updated post on VSXX here.

VSXX, an ETF based on VSTOXX Short-Term Futures Index is trading for two months now (summary here, official Braclays page on VSXX is here, and here is the explanation of the index the ETF is based on). The VSTOXX futures trade in €, but as far as I understand European traders have two options as ETF trades in London in £, and in Germany in €. Below is the plot of VXX ($) vs VSXX (€)



I've read the description on both indexes and calculation algorithm seems to be the same for both. However the most interesting nugget of information is found in the summary on Deutsche Börse website here, page 5 figure 2. The chart compares performance of two volatility indexes - VIX and VSTOXX vs. their short-term futures indexes. The cost of carry, that eroded VIX futures index to about a third of its starting value in 4.5 years had almost no effect on VSTOXX - based index. Below I reproduce the charts from my data. SPVIXSTR is S&P 500 VIX Short-Term Futures Index, and VST1MT is Euro STOXX 50 Volatility Short-Term Futures Index.





I was going to type up some stats based on the data above, but picture's worth a thousand words. Over the last year and half VXX declined precipitously, however such decline is probably not in the cards for VSXX. While the term stucture of VIX futures is rather steep, making the roll costly, VSTOXX term structure appears to be relatively flat.

Honestly, I cannot say that I know the reason for that. One possible explanation is that I made a mistake , and there is a critical difference in the calculation of two indexes that escaped my attention. That seems unlikely, as Barclays' publication obviously implies that the indexes are comparable. Another explanation can be that there is a greater institutional demand for VIX futures than there is for VSTOXX futures, however to confirm that I would need to separate the effects of risk premium from statistical effects that also produce upward-sloping futures curve. Accomplishing that would be anything but simple.

Leaving theoretical issues aside it appears that smart traders can take advantage of different futures slopes by rolling into the contracts with the cheapest cost of carry, possibly financing the trade with selling the expensive roll. For example consider an investor who is long a broad portfolio of US stocks and wants to hedge against volatility spike. Holding VXX or rolling VIX futures can be very expensive in the long run; doing the same thing with VSXX / VSTOXX futures may be cheaper, while providing a proxy for VIX in the time of volatility spikes.

Edit Dec 7, 2010: See my updated post on VSXX here.