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The VIX, or the “fear index” as it’s often known, can make for attention-grabbing news, but many investors don’t know what it really means.

The idea of a volatility index started decades ago, and real-time data has been provided by the Chicago Board Options Exchange (CBOE) since 1993 in the form of the VIX. It wasn’t until 2004 that the CBOE provided a way to trade the VIX with the introduction of futures. VIX options followed in 2006. After the financial crash in 2008, firms created ETFs tracking the fear index, making VIX-watching a more popular pastime for everyday investors.

What is the VIX, really?

The VIX is supposed to represent the expected volatility of the S&P 500 Index over the next 30 days. It’s calculated by using weekly and monthly options on the S&P that expire 23 to 37 days ahead, estimating the implied volatility based on the pricing of those options.

The VIX is quoted in percentage points, and estimates one standard deviation on an annualized basis. In 2015, the VIX averaged 16.7, spiking to over 50 at one point. In 2016, the average was 15.8, with a few spikes over 30. But in 2017, the average was just 11.1, with a high of only 17 (barely above the average just two years prior). During the first six weeks of 2018, the VIX has averaged 15, despite hitting an intraday high of 50 during a market correction.

To use the average of 2017 as an example, a value of 11.1 means that investors expect the S&P 500 to move 11.1% over the next year, within a probability of 68% (one standard deviation). The expected movement over the next month is 3.2%, which is 11.1 divided by the square root of 12 (number of months). This expected movement could be up or down.

Why is the VIX synonymous with fear?

Since the implied volatility of the VIX means the S&P 500 could move up or down, why does the market assume that the movement will be downward? According to the CBOE, the VIX moves in the opposite direction of the daily performance of the S&P 500 about 80% of the time. (January 2018 was an exception, as the fear index rose alongside the S&P 500 on several days.) But this correlation doesn’t mean the VIX has predictive value. In fact, OptionMetrics calculates that, at most, 1.2% of the movement in the VIX reflects market sentiment not already reflected in the S&P 500.

The fear in the fear index is not so much about the potential for falling stock prices, but the fear associated with the predicted volatility (either upward or downward). Volatility tends to create uneasiness, and the market is known to react more negatively to uncertainty, making stocks fall when volatility rises. If that explanation seems deficient, you’re not alone in thinking the VIX has its limitations.

Is the VIX a useful tool?

While a spike in the VIX is often concurrent with a downturn in the S&P 500, you can’t trade the VIX. Trading futures and options based on the VIX is complicated, unsuitable for many investors and can actually produce materially different results from the underlying VIX index.

ETFs built around the VIX make it accessible for more investors, but the performance of those ETFs can veer even farther off course than that of options and futures. Due to inherent shortcomings and continuous rebalancing costs, VIX ETFs are only meant for short-term hedging, and don’t work well as a form of prolonged market insurance. In fact, many VIX-based ETFs failed by a wide margin to produce their expected returns for even single days during the February 2018 market correction.

While the VIX falls short of expectations as market insurance, some pundits try to divine meaning from its longer-term trend. Similarly low levels to 2017 were seen on the VIX in 2007, prior to the financial crisis, but the VIX hit its low many months prior to the market crash.

The historically low VIX levels seen in 2017 have been interpreted by some as a sign of dangerous investor complacency, but that warning was bandied about for most of the year as the S&P rose 19.4%, and still remains up by 17% from the start of 2017 through the first six weeks of 2018.

Overall, the interpretations of the VIX are weak, and seem more like a continued search for meaning in a market indicator that may have seen more useful days.

Al and Mark Rosen run Accountability Research Corp., providing independent equity research to investment advisors across Canada. Dr. Al Rosen is FCA, FCMA, FCPA, CFE, CIP and Mark Rosen, is MBA, CFA, CFE.

Originally published in Advisor's Edge

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