The drop of more than 800 points in the Dow Jones Industrials (^DJI -1.20%) on Wednesday reminded investors once again that even during a bull market, downturns can come unexpectedly. That's a lesson that many investors in inverse volatility ETFs still remember quite well from earlier this year, when a similarly massive swing wiped out some shareholders entirely.
In the aftermath of the February plunge in the stock market, inverse volatility ETFs like the ProShares Short VIX Short-Term Futures (SVXY -1.51%) made some significant changes to their investment objectives. These changes weren't really welcomed at the time, as they came too late to prevent the losses they'd suffered and threatened to dilute any recovery from their plunge. However, the declines over the past week gave investors their first real look at what impact the changes had on protecting fund shareholders from abrupt downward moves, and the initial results look pretty promising.
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What made inverse volatility ETFs take a second look at their strategies
To assess how effective the changes that inverse volatility ETFs made in response to their devastating losses, it's useful to look back at exactly what happened in February. After a run to record highs, the Dow posted 1,000-point drops on two separate occasions early in the month, as investors feared that rising interest rates and global economic issues could threaten to end the nine-year-old bull market. In a single day, the CBOE Volatility Index more than doubled, and that caused one leveraged ETF in the space to fail completely. Even the ProShares fund suffered a loss of more than 80% on Feb. 6, reversing years of substantial gains.
Shortly thereafter, ProShares announced that it would change the way that its inverse volatility ETF gave investors exposure to the volatility market. Rather than seeking to deliver the full inverse daily movement of the volatility futures it tracked, ProShares said it would reduce its exposure, producing returns equal to just half of the inverse movement in volatility.
How this week went
As you'd expect, this week was another tough one for inverse volatility ETFs. However, the devastation wasn't nearly as bad as it would have been without the changes to the ProShares fund. In particular:
- On Wednesday, volatility spiked higher by more than 30%. However, the fund lost just 8%.
- Thursday's less severe loss in the market resulted in just a 5% fall in the fund's value, even though volatility levels rose another 17%.
It's important to note that those two days' worth of losses were enough to wipe out roughly six months of gains for the ProShares inverse volatility ETF. However, that's still a far cry from the roughly five years' worth of gains that got wiped out in February's swoon.
Is it safe to get back in the water?
The change in the ProShares inverse volatility ETF's investment strategy has had the desirable impact of reducing the severity of losses during market downturns. That benefit did come at the expense of less favorable positive returns during calm markets, and although the ETF's asset levels have risen somewhat from February's lows, they're still nowhere near their peak from before that big drop.
For the most part, volatility-linked ETFs are still intended as short-term plays, with a daily return focus that makes them less suitable as long-term holdings. Investors ignored that in the past and suffered as a result, and even though this week's experience shows that the funds are somewhat safer than they were before, anyone looking to buy shares still needs to understand the inherent risks involved with its investment strategy.
