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(John Foxx/(c) John Foxx)
(John Foxx/(c) John Foxx)

Volatility products offer tempting but dangerous investment Add to ...

The most lucrative place to park money during the last few months of market turmoil has not been gold or even U.S. Treasuries. It’s been funds linked to the “fear index.”

The Chicago Board Options Exchange’s Volatility Index, or VIX, is the global barometer of investor fear. The VIX It measures the implied volatility of major U.S. stocks over a 30-day period based on the prices of certain call and put options on the S&P 500 Index.

Investors can’t invest directly in the VIX. Instead, institutions and sophisticated investors buy or sell VIX futures contracts. Over the last few years, a handful of financial firms have simplified the mechanics of the underlying formula by creating exchange traded funds (ETFs) and exchange traded notes (ETNs) tied to the VIX. In return for management fees of less than 1 per cent, retail investors can play the VIX without ever needing to buy and sell complicated futures contracts themselves.

The most popular of these fund products, the iPath S&P 500 VIX Short-Term Futures ETN , clocked a three-month return of 102 per cent. VelocityShares Daily 2x VIX Short Term ETN (which essentially doubles down on the VIX), posted a whopping 225-per-cent gain in the same period, according to Morningstar Inc.

Investors looking at these returns and the mounting uncertainty in global markets might be tempted to jump in, even just to hedge part of their equity portfolios. But professionals warn otherwise.

“We don’t recommend these products for people,” said Tim Strauts, an ETF analyst at Morningstar in Chicago. “These products are much more volatile than most people realize. An investor may be used to seeing stocks rise and fall by 3 or 4 per cent a day. But the same day these products will rise and fall 10 to 20 per cent. There are not too many investors out there who can handle that type of swing.”

The wild ride is only half the problem. These funds are continuously rolling their positions in volatility futures. Short-term funds seek a maturity of only one month. Funds that track the VIX Mid-Term Index, such as the ProShares VIX Mid-Term Futures ETF, have an average maturity of five months. In either case, the constant buying and selling eats away at the investment because, in most cases, the new contract is more expensive than the last.

The iPath S&P 500 VIX Short-Term Futures ETN rolls one-30th of its approximately $1-billion portfolio every day. Over the past three years this has led to an annualized loss of the underlying asset of more than 50 per cent, Mr. Strauts said.

On a split-adjusted basis, the ETN has declined in value from more than $400 in early 2009 to $45.83 on Tuesday. The VelocityShares Daily 2x VIX ST ETN similarly has fallen from more than $100 since last fall to $67.89 on Tuesday.

Volatility products “are flawed products for consumers,” Mr. Strauts said.

The nature of these funds and notes demands that investors buy them to trade when they have a strong view regarding the market over the coming days, or weeks at most. This makes them a favourite of day traders, but not an ideal tool for hedging a portfolio.

Periods of high volatility in the stock market tend to be short-lived and are difficult to time, says Vikash Jain, vice-president, portfolio management, at ArcherETF Portfolio Management in Oakville, Ont.

“Unless your timing is absolutely impeccable, you are going to get hammered,” he said. “And if you are that good at timing, you might just as well sell the stocks.”

Mr. Jain says that if investors want to hedge their portfolios, they are much better off using a product that is more closely aligned with their actual stocks. Although his firm relies on asset allocation over hedging to manage risk, he says he has occasionally used ProShares Short S&P500 ETF as a short-term bearish hedge. The product has almost 100-per-cent negative correlation to the S&P 500, meaning it moves up when the index falls.

A similar type of fund for large caps listed on the Toronto Stock Exchange is the Horizons BetaPro S&P/TSX 60 Inverse ETF .

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