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NEWSLETTERS & ALERTS
Investments - Strategies
Investing in ‘Volatility ETPs’ Can Be a Crapshoot
by Howard Haykin
WELCOME TO VOLATILITY ETPs. Exchange traded products (ETPs) that offer exposure to stock market volatility (“Volatility ETPs”) have much in common with single roll craps bets. They are popular securities products because they’re simple to execute (i.e., they trade on exchanges like stocks), they are usually low-cost alternatives to mutual funds and actively-managed funds, and their prices can spike way up when U.S. equity markets plunge.
A widely followed indicator of equity market volatility and investor sentiment is the Chicago Board Options Exchange Volatility Index (the "VIX"). The VIX, commonly known as the “Fear Gauge” or the “Fear Index,” is derived from the price inputs of the S&P 500 Index put and call options. Inasmuch as the VIX cannot be bought or sold directly, investors must trade and exchange in Volatility-Linked Exchange Traded Products – i.e., Volatility ETPs - that track or hold investments in VIX futures indexes - though these securities do not directly track or reflect the VIX.
In a publication to investors (see link below), Fidelity Investments describes Volatility ETPs as complex products that are typically held for short periods of time as part of a trading strategy rather than as a buy-and-hold investment. Fidelity further notes that Volatility ETPs actually track VIX futures indexes, and not the VIX. This distinction creates 2 big challenges:
- VIX ETPs don't reflect the VIX index. By any measure, VIX futures indexes (and, therefore, VIX ETPs) do a lousy job emulating the VIX index. The VIX index is truly uninvestable, and over periods of a month or a year, the return pattern of VIX ETFs will differ radically from that of the VIX index.
- VIX ETFs tend to lose money - significant money - in the long run. VIX ETPs are at the mercy of the VIX futures curve, which they rely upon for their exposure. Because the typical state of the curve is upsloping (in contango), VIX ETPs see their positions decay over time. Decay in their exposure leaves them with less money to roll into the next futures contract when the current one expires. The process then repeats itself, leading to massive double-digit losses over the course of a typical year. These funds almost always lose money long term.
INVESTORS BEWARE. Volatility ETPs entail significant risk and are intended for very experienced, aggressive, sophisticated investors who actively manage their investments daily. Volatility ETPs are intended for short-term trading and should not be used as a buy and hold investment. Volatility ETPs should not be expected to appreciate over extended time periods. In the real world, traders stay in VIX ETPs for 1 day, not 1 year. VIX ETPs are emphatically short-term tactical tools used by traders.
For further details on the CBOE Volatility Index and Volatility ETPs, click on …