Volatility ETFs: Weapons of Mass Portfolio Destruction?

The exchange-traded fund industry has grown by leaps and bounds ever over the past two decades. While it is true that most ETF products have been a blessing for most investors, there are some "exotic" products that have devastated many portfolios.

 Volatility-based exchange-traded products are one such type of these "exotic" products that have given investors more trouble than peace. Traditionally, these products are aimed to provide a hedge against the fluctuation in the equity markets. They strive to achieve this by placing their bets on the CBOE Volatility Index (VOLATILITYINDICES: ^VIX  ) , which normally moves in the opposite direction of U.S.equities as represented by the S&P 500 Index (SNPINDEX: ^GSPC  ) .

As exciting as this investment objective may sound, these products do little to achieve it. Let's have a closer look at these products and understand why.

Beware contango
Almost all of the volatility-based products, such as the iPath S&P 500 VIX Short Term Futures ETN (NYSEMKT: VXX  ) and iPath S&P 500 VIX Medium Term Futures ETN (NYSEMKT: VXZ  ) , seek exposure in the Volatility Index by taking positions in VIX future contracts. This is primarily because investing directly in the VIX is not possible, as the index of volatility does not include any stocks. On the contrary, it is primarily an index of "fear," measuring the implied (i.e., expected) volatility in the S&P 500 Index over the next 30 days.

Recently, volatility-based ETFs have had to deal with "contango." This is a situation in which the futures price is greater than the spot price. However, on the date of expiry, the spot and futures price converge and become equal as constant arbitrage takes place by various market participants until the date of the expiry.

These products basically take positions on varying expiry dates across the volatility futures curve, and in order to gain continuous exposure, they roll over (i.e., swap) positions. This rollover of positions magnifies the losses that a lack of volatility has created in these products.

As a result, these ETFs have posted losses significantly greater than the CBOE Volatility Index, as the following chart shows:

VXX Chart

VXX data by YCharts.

If you had invested $1,000 in the VIX Short Term ETN in the beginning of the year 2011, you would have only $110 left today. Such is the effect of contango!

Term structure matters
What's curious is that although the investment objective of both the products is the same, the VIX Short Term ETN has suffered worse losses than the VIX Medium Term ETN. The reason has to do with something called "term structure."

The VIX Short Term ETN gains exposure in the immediate first- and second-month volatility futures contracts and rolls over positions on a daily basis. These immediate-month contracts are by nature more volatile and subject to higher contango effect than the far-month ones, as they are liable to expire sooner. Therefore the VIX Short Term ETN has faced high levels of contango, causing losses to be magnified.

On the contrary, the VIX Medium Term ETN seeks to reduce the contango effect by spreading out its exposure across the fourth-, fifth-, sixth-, and seventh-month volatility futures contracts. Therefore its losses, though still huge, have been smaller than the Short term ETN's.

Investors should also note that both these products charge hefty expense ratios of 0.89% each, further limiting their already minimal profit potential.

The bottom line
Although these products have many shortcomings, it would be unfair to say that they have absolutely no value. For the short-term trader, these products can be great opportunities to make money, provided one has a thorough understanding of them.

Nevertheless, as a long-term investment avenue, these ETFs should most definitely be avoided at all costs, as they are most likely to cause more harm than good.

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