Please ensure Javascript is enabled for purposes of website accessibility

The Newest Danger for Volatility ETFs

By Dan Caplinger - Mar 5, 2018 at 6:15PM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

Did this latest move really help investors -- or hurt them again?

One of the most successful ways to invest in 2017 was to buy inverse volatility ETFs. The market's calm move upward throughout the year helped these investment vehicles, which thrive on a lack of choppy moves in stocks, produce incredibly strong returns. Yet when volatility levels spiked higher in early February, the resulting collapse caused massive losses that led one inverse volatility ETF to shut its doors.

Many investors didn't seem to understand the danger that they could lose everything by investing in inverse volatility ETFs. Yet as investors in the inverse volatility ETF ProShares Short VIX Short-Term Futures (SVXY -0.36%) have discovered, there's another risk that exchange-traded fund investors have to deal with: changes in investment models that can dramatically change the way that a fund operates without having to get shareholder approval.

White mosaic tiles spelling ETF on a yellow mosaic tile background.

Image source: Getty Images.

A unilateral move from ProShares

Initially, ProShares said that the inverse volatility ETF's plunge of more 80% on Feb. 6 "was consistent with its objective and reflected the changes in the level of its underlying index." ProShares claimed that "we intend to continue to manage the fund as usual" going forward. At that point, it seemed as though ProShares was comfortable that its investors understood the risks of its volatility products and were prepared to keep using them in their investment strategies going forward.

Yet just three weeks later, ProShares changed its tune. In a press release, the ETF manager said that it would change the investment objective on its inverse volatility ETF. Rather than looking to track the inverse movements of an index tied to the S&P 500 VIX futures contracts on a daily basis, ProShares said that the fund would instead look to produce one-half of the inverse of those daily moves. For example, under the old methodology, a 10% move higher in volatility should have produced losses of 10% for the ETF. Going forward, ProShares would instead look to produce a 5% loss in that circumstance.

ProShares also made changes to one of its leveraged volatility ETFs. The ProShares Ultra VIX Short-Term Futures (UVXY 0.79%) had looked to produce double the daily change in its target volatility index, but the fund manager said that going forward, the investment objective would be to produce 150% of the daily change instead.

What the changes did to investors

The changes were made with minimal notice to investors, as the press release on Feb. 26 discussed the changes effective at the close of business on Feb. 27. ProShares said that it would have to obtain certain regulatory approvals to make the changes permanent, but that didn't stop the company from moving forward immediately. ProShares argued that "it was in the best interests of the funds and their shareholders to promptly implement this change."

The changes had two substantial impacts. First, investors in the funds suddenly found themselves with instruments that no longer served the purposes for which they had bought them. In response, they either had to adjust their exposure to the volatility ETFs accordingly to account for their reduced leverage, or they had to find replacement securities in their place.

Even more unfair was the impact that the move had on holders of options of volatility ETFs. By making the change in investment objective, ProShares dramatically reduced the likelihood of dramatic movements in the volatility ETFs. That reduced the value of options to buy or sell ETF shares, especially those options that would only be profitable in the event of large movements in the underlying share price. In some cases, the change by itself effectively wiped out options investors that were betting on a repeat of early February's volatility spike -- all while failing to give those investors enough time to do anything about it.

Dealing with unstated risk

Although the prospectus for the ProShares funds talks about a large number of potential risks, it didn't include the fact that the investment manager reserved the right to change the investment objective unilaterally with minimal notice and no consent from shareholders. Even now, the amended prospectus lacks any such language.

Many volatility ETF investors have learned the hard way about the risks involved in this investing niche. What happened in early February was a clear risk that any investor in these securities should have known about, as it was clearly stated in the prospectus and other documents describing the funds. That ProShares would unilaterally change how its ETFs invest, by contrast, was a risk that many investors never saw coming -- but it's one that anyone who trusts their money to a fund manager has to contemplate as a possibility going forward.

Dan Caplinger has no position in any of the stocks mentioned. The Motley Fool owns shares of ProShares Short VIX Short-Term Futures ETF. The Motley Fool has a disclosure policy.

Invest Smarter with The Motley Fool

Join Over 1 Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now

Stocks Mentioned

ProShares Trust II - ProShares Ultra VIX Short-Term Futures ETF Stock Quote
ProShares Trust II - ProShares Ultra VIX Short-Term Futures ETF
$8.98 (0.79%) $0.07
ProShares Trust II - ProShares Short VIX Short-Term Futures ETF Stock Quote
ProShares Trust II - ProShares Short VIX Short-Term Futures ETF
$55.94 (-0.36%) $0.20

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

Related Articles

Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning analyst team.

Stock Advisor Returns
S&P 500 Returns

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 08/17/2022.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.