Smart investors understand that in order to earn healthy returns, you have to be willing to take on risk. But along the way, some investors decided that the better way to get rich was to make bets on the overall risk levels in the stock market. As investors in volatility-based ETFs learned this year, using investment strategies that rely on market anxiety can create big losses if gloom-and-doom predictions don't come to pass.
Betting on disaster
The idea behind volatility ETFs couldn't be simpler. Just as stock prices move up and down with prevailing market conditions and company-specific events, the speed at which prices move in either direction also changes over time. Think back to 2008, for example, when it seemed like the market routinely soared or plunged by triple-digit moves. During times of high stress, markets tend to move violently, and volatility ETFs were created in an attempt to harness and profit from those conditions.
But how that idea turns into a practical, tradeable investment is a bit more complicated. The typical measure of volatility comes from the Chicago Board Options Exchange, whose S&P Volatility Index (VOLATILITYINDICES:^VIX) is arguably the most-followed measure of volatility today. Also known as the "fear index," the volatility index looks at options prices to determine investors' expectations of volatility in the future. Because implied volatility of options tends to rise when stock markets drop and fall in rising markets, the fear index moniker is largely apt.
As a result, volatility ETFs tend to track the S&P Volatility Index in some way. For instance, the iPath S&P 500 VIX Short-Term Futures ETN (NYSEMKT:VXX) tracks an index that incorporates the two closest-month VIX futures contracts. The VelocityShares 2x VIX Short-Term ETN (NASDAQ:TVIX) takes it a step further, using a leveraged-ETF approach to magnify movements in the volatility index.
Crying wolf in the market
The problem with volatility ETFs this year was that no disaster actually occurred. Coming into 2012, it certainly seemed like uncertainties could cause plenty of havoc for the markets:
- Sovereign debt woes in Europe jeopardized not only European companies but also U.S. multinationals that do a lot of business across the Atlantic. Moreover, with Banco Santander (NYSE:SAN) and other financial institutions exposed to problem debt, a failure to solve the crisis could have led to destabilization of the global financial system.
- Among faster-growing emerging market nations like China, a slowdown in growth caused fears of another global recession. Moreover, the Chinese stock market has behaved badly all year, plunging to levels last seen at the worst parts of the 2008-2009 global bear market.
- In the U.S., high unemployment, weak growth, and political wrangling during an election year all left the nation on unstable ground. As the year progressed, the fiscal cliff got closer and remains a potential wild card of risk.
Despite all these uncertainties, though, the volatility index has remained extremely low. Investors have been complacent about the risks in the market, and while stocks haven't moved straight up, they've thus far answered corrections and less extreme declines with buying interest.
As a result, volatility ETFs betting on rising volatility have gotten hammered. The standard iPath ETN has declined almost 80% since the beginning of the year, while the leveraged version has fallen by a whopping 97%.
On the other side of the coin, ETFs betting against volatility have soared. The VelocityShares Daily Inverse VIX ETN (NASDAQ:XIV) has nearly tripled so far in 2012.
The smart way to protect against risk
Trying to defend against risk is every investor's goal. The challenge, though, is knowing when a tool will be useful for that task, as well as understanding that some risks are worth taking. When risk-fighting investments like volatility ETFs end up introducing risks of their own, they stop serving their purpose. The better way to handle risk management is to look more closely at your portfolio and find investments whose risks, while unavoidable, are worth the potential returns they'll generate.
Fool contributor Dan Caplinger has no positions in the stocks mentioned above. You can follow him on Twitter @DanCaplinger. The Motley Fool has no positions in the stocks mentioned above. 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 Motley Fool has a disclosure policy.