During the market implosion on Monday, you may have heard the word “volatility” quite a bit. Along with that, you may have head reference to volatility products like “the VIX,” and an ETF called VelocityShares Daily Inverse VIX Short-Term ETN (NYSE:XIV) having a “liquidation event.” What does this all mean and why should you avoid these ETFs?
The “VIX” is the CBOE Volatility Index. It is an index derived from the prices of options premiums in the S&P 500 Index. As the market becomes more volatile, the price of options increases. Thus, more volatility equals higher options prices, and the VIX will rise. The higher the number of the VIX, the more volatility we see in the market.
The VIX, however, is not an actual measurement of volatility. It measures expectation of volatility. It is just an assumption based on option premiums — the price to buy or sell the right to buy or sell a stock.
Generally speaking, if the VIX is below 20, we have a stable and lower risk market. As the VIX moves over 20, there is more risk entering the market. It gets even more complex, but that’s the basics of what you need to know.
Naturally, some genius came up with the idea of being able to buy or short this index. In other words, they came up with a way to create a derivative of an index which isn’t even based on earnings or some hard value of a hard asset or a share in a company or anything that has a profit or loss or pays dividends. It’s based on an expectation of something totally unpredictable: volatility.
If this sounds like gambling, that’s exactly what it is. Literally. You may as well go to Vegas and make casino bets. Because the VIX and its ETF derivatives are not investments!
The Difference Between the VIX and Investing
Investments in the stock market have a positive expectation over time. That’s because the economy always grows over the very long term. Stock prices follow earnings growth, and thus the stock market rises over time.
The VIX moves from minute to minute with no idea where it will go from one moment to the next. It is literally gambling.
One of the popular ETFs to buy the VIX is the iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX). Yet even this is a derivative of a derivative. It doesn’t actually track the VIX but the value of futures contracts for the VIX. There is a huge problem with this, in that futures contracts constantly expire, and new ones are put in place.
Thus, as the futures contracts move day-by-day toward expiration, the value of those contracts declines, so the VXX value itself decays to the tune of 30% per year. Think of it as built-in depreciation.
Thus, if you invested $1000 in the SPDR S&P 500 ETF (NYSESRCA:SPY) on March 26, 2004, it would today be worth $3,210 with dividend reinvested. If you did the same with VXX, it would be worth 17 cents. That’s right — 17 cents. Because the VXX constantly degrades over time, it constantly must reverse split.
The long-term value of this investment is zero, and the prospectus even says it.
You are not only gambling, then, if you hold this security, you are literally just handing all your money to the casino.
Just Stay Away
If you think that’s bad, things are even worse for holders of the short-sale version of the VIX, the VelocityShares Daily Inverse VIX Short-Term ETN (NASDAQ:XIV). The market was extremely volatile on Monday, of course. That means if you were short the VIX, expecting little or no volatility, the trade went very much against you. It was so bad that after-hours on Monday, the XIV fell 90%.
In the prospectus, it says the product can be liquidated if its value falls by 80% or more in a certain period of time. Thus, trading is frozen, and whatever value your share is at that time is what you receive.
In other words, holders of this ETN were mostly wiped out.
In other words, never put money into a volatility product. They have no place in your portfolio.
Lawrence Meyers is the CEO of PDL Capital, a specialty lender focusing on consumer finance and is the Manager of The Liberty Portfolio at www.thelibertyportfolio.com. He does not own any stock mentioned. He has 23 years’ experience in the stock market, and has written more than 2,000 articles on investing. Lawrence Meyers can be reached at [email protected].