5 Lessons Learned From VIX ETFs

Don't enter VIX ETFs without a lot of caution (and risk managment)

The CBOE VIX Volatility Index is an interesting animal that has grown to become one of the most heavily watched indicators of fear and greed in the market.

This index functions by measuring near-term volatility expectations from options activity on the S&P 500 Index. It’s calculated on an intra-day basis, so investors are able to watch as implied volatility expands or contracts in real time.

The CBOE has a nice primer on how this is accomplished that you can read here.

As many ETF investors know, you can’t invest directly in an index. So the forward-thinking asset managers at Barclays, ProShares, and VelocityShares set out to create several products to help you invest in the movement of the VIX Index. According to data from ETF.com, there are currently 20 dedicated exchange-traded funds and exchange-traded notes that attempt to track this index with varying degrees of success.

The two largest funds in this space are the iPath S&P 500 VIX Short-Term Futures ETN (VXX) and VelocityShares Daily Inverse VIX Short Term ETN (XIV). Both of these funds currently have more than $1 billion in assets under management.

VXX is a bet on the expansion of volatility, which typically comes during a correction or choppy stock market action. Conversely, XIV is an inverse play that rises when volatility contracts. This fund is intended to move higher as stocks move higher and greed takes a more prominent position in investor sentiment.

There are also many other flavors of VIX funds that offer varying degrees of unique tracking and index construction methodology. Nevertheless, XIV and VXX work well as benchmarks to understand this unconventional asset class.

I have been watching and even invested small amounts in these funds for my personal accounts at one point or another, and these are the lessons I have learned from the experience.

  1. They aren’t for the faint of heart. By their nature, VIX funds are a non-correlated index that are essentially a way to measure when the stock market starts to get shaky. It’s difficult to use these as a forecasting tool, and they are often susceptible to very fast swings in price. They should only be used by disciplined traders, investment professionals, or those who understand their unconventional nature. In my opinion, they should only be held for very short periods of time with a tight stop loss to guard against significant downside risk.
  2. They don’t track all that well. These VIX funds work by tracking futures contracts similar to a commodity fund like oil or natural gas. That in itself causes problems in accurate price movement over long periods of time as complicated forces like contract rolls, contango, and expenses work against these products. The chart below depicts an overlay of the actual CBOE VIX Volatility Index and VXX. The movements are certainly correlated to a degree, but you can see how over time the price of the exchange-traded product continues to decay versus the spot price of the index.

vxx

  1. They aren’t cheap. The listed annual expense ratio of VXX is 0.89% and XIV is 1.35%. It should be expected that a fund investing in futures contracts will naturally generate higher expenses because of the complicated nature of the process. Nevertheless, it’s important to understand that these funds are going to eat into your pocketbook.
  2. Some come with tax headaches. Most of the investable VIX funds are structured as exchange-traded notes, which do not experience adverse tax consequences. However, if the fund is structured as an exchange-traded fund, it may be susceptible to tax consequences in the form of a K-1 that must be accounted for as well. The K-1 is generated because you are participating as a shareholder in a partnership rather than a trust. It goes without saying that you should carefully read the prospectus before investing in any of these funds.
  3. They are entertaining to watch. Regardless of whether you use these vehicles, they can be entertaining to watch and also offer some insight into the market’s fickle machinations. VIX ETNs allow individual investors the ability to monitor in real time the current sentiment towards stocks and may provide a piece of the puzzle for short-term traders. They also offer a technical dynamic that may be useful for investors who are fans of relative strength or other momentum indicators. Sharp inflection points in the VIX may point towards a turning point in the market that precedes a big move (up or down).

The bottom line is that these products are primarily geared for advanced users with a high tolerance for risk and sophisticated knowledge of the markets. Traders who choose to dabble in these funds should only do so with a well-defined risk management plan that protects your capital in the event of a reversal.

David Fabian is Managing Partner and Chief Operations Officer of FMD Capital Management. To get more investor insights from FMD Capital, visit their blog.

Learn More: 3 Tenets of Sound Risk Management

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