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Benchmarks that use algorithmic strategies to capture spikes in equity market volatility are all the rage. But they don’t come cheap.

*[This article first appeared on our sister site, IndexUniverse.eu] *

Exchange-traded funds based on volatility indices have become big business. But the performance of the first generation of volatility indices left a lot to be desired, and consequently a new breed of indices based on volatility timing strategies is emerging.

The thing that primarily attracts investors to the VIX index and to related volatility products is the index’s historical negative correlation to stock prices. Not only does the VIX move in the opposite direction to equities, but the negative correlation is much larger in magnitude when the market moves down than it is when the market moves up. This fact makes volatility indices of interest to investors seeking to diversify their portfolio risk or protect their portfolio from extreme losses or “tail-risk" events such as the equity market collapse of 2008-09.

Indices like VIX and VStoxx are designed to represent the expected volatility of an underlying index—in this case the S&P 500 and Euro STOXX 50, respectively.

These indices are statistical measures of market volatility, based on option prices. The constituents of the VIX are listed options with a 30-day maturity on the S&P 500 index. Unfortunately it is impossible to invest directly in the VIX index itself. Anyone seeking to take advantage of the negative correlation between the VIX and stock prices needs to find a tradeable instrument that behaves like the index.

The purest instrument for trading volatility is the variance swap. Variance swaps are, in essence, a contract for difference between a pre-agreed level of volatility (the “strike”) and the actual ”realised” volatility of a specified asset over an agreed period. The strike is set using prevailing market rates such that the swap starts with zero value. Variance swaps have historically been traded over the counter without an official fixing—the lack of which makes them relatively opaque and as a result unattractive for use in indices.

Volatility is also available in futures format. The CBOE launched futures contracts on the VIX index in 2004, followed a year later by the launch of futures on the European VStoxx, VDAX and VSMI indices on Eurex. There are important differences between variance swaps and futures. Volatility index futures pay out according to the value of the underlying volatility index at expiry, a value that is itself an implied volatility. The return on a futures position, in other words, depends on a change in the expected future volatility of the underlying asset. By contrast, variance swaps’ payout depends on the difference between the initial (strike) level and the actual level of an asset’s volatility during the period of the swap.

While VIX futures also offer negative correlation to stock prices, they are not as sensitive to changes in equity prices as the VIX itself. For example, an index of short-term futures has a daily “beta” of about 0.5 to spot VIX, whereas a mid-term futures index has a daily beta of about 0.2 to the spot VIX. In spite of these differences and largely as a result of the tradeability they offer, futures are the main instruments used in investable volatility indices.

To understand why volatility indices based on futures contracts can deliver a different return to the “spot” VIX index itself, it’s necessary to look at how the indices are put together.

Because futures expire regularly, any long term investment based on them requires a mechanism to maintain the desired exposure to the underlying asset. For volatility index futures this is most often achieved by continuously shifting exposure between two futures contracts in order to maintain a constant maturity. S&P publishes a family of indices that represent exposure to different maturity segments of the VIX futures curve.

The two most popular indices are the S&P 500 VIX Short-Term Futures index, which measures the return from a long position in the first and second month VIX futures contracts, with a proportion of the exposure being rolled daily from the first to the second month; and the S&P 500 VIX Mid-Term Futures index, which similarly references the fourth, fifth, sixth and seventh month VIX futures contracts (VIX futures contracts are currently quoted as far as nine months ahead, with contract dates a month apart).