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Warren Buffett is famous for saying that you should be greedy when others are fearful. One way investors can satisfy their inner greed during times of trouble is to invest in fear itself -- and you're likely to have many more chances to buy fear-based investments in the near future.

Nothing to fear but fear itself
The Chicago Board Options Exchange unit of CBOE Holdings (Nasdaq: CBOE  ) announced recently that it plans to expand on its popular volatility index, which many refer to as the "fear index." While the current index tracks the volatility implied by prices of S&P 500 options, the CBOE plans to provide new ways to track and invest in the volatility of a host of other investments.

The CBOE's plans include tracking for both select individual stocks as well as popular exchange-traded funds. In particular, the CBOE has asked the Securities and Exchange Commission for permission to allow options tied to indexes it recently created on five individual stocks. The stocks that could soon have their own volatility-based options include Apple (Nasdaq: AAPL  ) and IBM (NYSE: IBM  ) . On the ETF front, the CBOE is creating indexes on six different ETFs, ranging from iShares Silver Trust (NYSE: SLV  ) to emerging market funds like iShares FTSE China (NYSE: FXI  ) and iShares MSCI Brazil (NYSE: EWZ  ) .

Presumably, the ETF-based volatility indexes will pave the way for future SEC filings for options trading similar to what the exchange has filed for with its individual-stock volatility measures. In addition, where there's an index, there's a benchmark that a prospective new ETF could eventually track. Soon, you could have several new ETFs with ties to each of these volatility indexes.

The big question you need to ask yourself is what purpose volatility-based investments serve. Although some believe they add diversification, currently available choices haven't performed very well over long periods of time.

A perfectly bad investment
For proof, all you have to do is look at the iPath S&P 500 VIX Short-Term Futures ETN (NYSE: VXX  ) . With a big gain yesterday, the exchange-traded note has jumped 37% from its February lows as the market rally finally started to stumble.

Over the course of its two-year history, though, the iPath ETN has lost well over 90% of its value, suffering a reverse stock split and destroying anyone who used the investment for the long haul. Part of that fall came from the ETN's poor timing; it came out in January 2009, near the height of the market meltdown when volatility was at very high levels.

But much of the loss came from a phenomenon that has plagued commodity-based ETFs: contango. The iPath ETN uses futures and therefore has to trade in and out of new contracts as old ones expire. Over time, because of the relative prices of current- and future-month futures, the ETN's value has steadily eroded. A similar ETF that has a longer-term approach and trades in and out of futures contracts less frequently, the iPath S&P 500 VIX Medium-Term Futures ETN, has had less trouble with value erosion, but it's still down more than 40% since its early 2009 inception.

Even for short-term investors, VIX-based investments haven't been all that useful. The iPath ETN's correlation to the S&P has been almost perfectly negative; that is, volatility rises when the S&P falls and vice versa. That may sound useful, but if that negative correlation is perfect, all the two investments do is cancel each other out, leaving investors with the frictional costs of expenses and futures-related contango.

Arguably, volatility-tracking investments might be more useful with a narrower focus on niche ETFs or individual stocks. There, overall volatility can increase or decrease independent of the stock's movements, such as immediately before an earnings announcement or other important news event.

But what it really boils down to is this: Looking at volatility takes your attention away from the companies you're investing in and instead shifts your focus to short-term share prices. That's not what most long-term investors really want or need.

Don't be afraid
If the current correction turns into a longer bout of bearishness, then you can definitely expect to see a lot more volatility-linked investments. Keep in mind, though, that no matter how well they do in the short run, their longer track record suggests a much less auspicious end result for your portfolio.

Invest in ETFs you can believe in even when fear is rampant. Click here to read The Motley Fool's special free report, "3 ETFs Set to Soar During the Recovery," which includes great funds you shouldn't miss.

Fool contributor Dan Caplinger has faith in the investing herd to follow the latest trend. He owns shares of iShares Silver Trust. The Fool has written naked calls on iPath S&P 500 VIX Short-Term Futures ETN. Motley Fool Options has recommended a bull call spread position on Apple, which is a Motley Fool Stock Advisor recommendation. The Fool has written puts on Apple and owns shares of Apple and IBM. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy is red hot baby!

Read/Post Comments (3) | Recommend This Article (16)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 17, 2011, at 6:58 PM, kabrink wrote:

    So.....I conclude that the smart thing to do is to buy CBOE.

  • Report this Comment On March 28, 2011, at 10:01 AM, obiwan48 wrote:

    All ETF's that use futures/swaps, etc should have a warning label attached to them in huge red letters.

    I'm surprised that there has not been multiple

    class action law suits by investors (thinking it was a smart way to play a sector) against the designers and sales agents of these products that tout them as the best things since sliced bread.

    They're really quite destructive and any professional that is selling them in investors is potentially doing a great diservice to their client.

  • Report this Comment On April 02, 2011, at 12:08 PM, RRobertsmith wrote:

    yes, totally agree with obiwan48 on this, as above..red lettered disclaimer should be manditory.

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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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11/24/2014 3:59 PM
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