It's never been a better time for young people to start investing, and many have turned to the Robinhood mobile app to buy their first stocks. The stocks Robinhood investors are buying have inspired a lot of debate about their suitability for people who are new to the market, but it's still good to see newcomers embracing the idea of getting their money to work through investing.
Yet thousands of Robinhood investors are actually taking the opposite view on stocks. Rather than expecting good times ahead, these bearish app-users have focused their attention on ETFs that are tied to stock market volatility. These volatility ETFs typically do rise in value when stocks fall, but their long-term behavior leaves a lot to be desired.
The idea behind volatility ETFs
Fund companies designed volatility ETFs to track what's known as the S&P Volatility Index (VOLATILITYINDICES:^VIX), or the VIX for short. Many market participants refer to the VIX as the "Fear Index," because it tends to go up when the market falls sharply but then go down when the market recovers.
Volatility ETFs come with different characteristics, and three in particular have made their way into a large number of Robinhood investors' portfolios. The most popular is ProShares Ultra VIX Short-Term (NYSEMKT:UVXY), with more than 16,000 investors counting it among their holdings. iPath Series B S&P 500 VIX (NYSEMKT:VXX) weighs in with almost 5,400 investors, and another 3,400 Robinhood users own shares of ProShares VIX Short-Term Futures (NYSEMKT:VIXY).
Two of these ETFs have the same investment objectives, but one differs. The regular ProShares ETF and the iPath offering tries to achieve a daily return that exactly matches the daily change in short-term futures contracts tracking the VIX. The ProShares Ultra ETF is designed to offer a leveraged return equal to 1.5 times the daily change in VIX futures.
Volatility ETFs can work extremely well when markets plunge over short periods of time. Consider this best-case scenario for the funds, which happened during the coronavirus bear market:
- The regular ProShares volatility ETF jumped 405% from Feb. 19 to March 18.
- The iPath fund did just a little better, climbing 409%.
- The leveraged ProShares Ultra ETF exploded higher even further, with gains of 932%.
It's those kind of quick paydays that many new investors who gravitate to volatility ETFs want to see.
Why volatility ETFs aren't ideal long-term investments
The problem, of course, is that you can't be sure exactly when that big market crash is going to happen. In the meantime, volatility ETFs don't make very suitable long-term investments, because they're designed with daily returns in mind.
As an example, look back two years with these three funds. With a market scare in late 2018 in addition to the COVID-19-inspired bear market, you'd think it would've been a pretty good period for volatility ETFs. However, the regular ProShares and iPath ETFs are down about 3% over those two years. The ProShares Ultra ETF is down more than 40%.
In other words, even with those big gains during turbulent times, volatility ETFs lost even more ground when times were good for the stock market. That left long-term investors in those ETFs with overall losses.
The better choice
Some Robinhood investors are likely trying to time a big market drop perfectly, but others might simply think that owning a volatility ETF can help you avoid the pain of stock market crashes. Yet that's not the best philosophy to have about your investing.
Unfortunately, volatility is the price investors pay for the attractive long-term gains in stocks. Investors should seek to control and manage volatility rather than getting rid of it, because eliminating risk typically also eliminates good returns.
The better choice is to identify stocks of high-quality companies and buy shares with the intent of holding them for the long run. That way, you'll participate in the success of companies whose businesses you understand and believe in. When volatility hits and stock prices fall, having cash on hand to take advantage can become some of your most profitable investments.
Volatility ETFs are interesting investment vehicles for short-term traders. Those Robinhood investors who have a longer-term mindset, though, should steer clear and focus more of their attention on great businesses.