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High-risk volatility-linked exchange-traded funds have benefited from the wild market swings caused by the economic fallout of the COVID-19 pandemic. While it can be a money-making bet, portfolio managers caution investors against volatility and inverse volatility ETFs plays without fully understanding the complexity of these funds.

Volatility and inverse volatility ETFs track the CBOE Volatility Index (VIX), a gauge of expected market swings in S&P 500 options in the next 30 days. And VIX funds, devices for wagering on sharp market movements and a devastated economy, have seen some of the highest returns among all ETFs since February.

“Not surprisingly, the best performing ETF league for the month of February is crowded by single long VIX ETF and ETNs [exchange-traded notes],” Daniel Straus, vice-president of ETFs and financial products research at National Bank Financial Inc., said in a February note.

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The VIX, also known as the “fear index” because it rises during times of market turmoil, climbed to a record close of 82.69 on March 16 as major U.S. indexes plummeted, beating its last market-close peak, from around the time of the 2008 financial crisis.

VIX ETFs, which use futures contracts to bet on market volatility, typically move in the opposite direction of major indexes. And inverse volatility funds, which are used to bet against turmoil, tend to rise as markets stabilize.

The VIX has tumbled in the past two weeks to around 40 as markets rallied but is still flying high above its average 2019 level of 15.

As volatility inches toward normal levels, some investors are betting on a short-term return to stable markets, according to David Kletz, a vice-president and portfolio manager at Forstrong Global Asset Management Inc. But continuing uncertainty regarding the reach of the pandemic, the extent of an economic downturn and rapid policy changes will continue to send markets spiralling, he says.

Volatility funds are more complex than typical ETFs that hold stocks and bonds because they include short- or long-term futures contracts with varying degrees of leverage. Some of the largest VIX funds are also the riskiest, Mr. Kletz says.

The largest VIX-linked exchange traded product, VelocityShares Daily 2x VIX Short Term ETN (TVIX), tracks an index of futures contracts on the S&P 500 VIX Short-Term Futures Index at 200-per-cent leverage on the volatility.

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TVIX holds $1.4-billion in assets and gained more than 430 per cent over the previous three months as of April 9, according to Bloomberg. Since it provides twice the returns of the S&P 500 VIX Short-Term Futures Index, it acts as a tool to guard against a slump in equity prices. But when volatility subsides, investors also lose twice as much.

“If you get your call wrong, then it’s twice as wrong,” Mr. Kletz says. “We’re not big into leveraged ETFs that have two and three times the exposure, so this isn’t an attractive approach.”

And since the funds are reset daily and the maturing futures contracts are sold to purchase newer ones, the “roll risk” – which is the cost of selling a contract at a loss or purchasing a new one at a higher price – can weigh on the ETF’s performance.

While unleveraged VIX products were the top-performing ETFs in February, excluding leveraged and inverse volatility ETFs, they returned less than half of the index, according to National Bank. The VIX surged to 40.1 on Feb 28, 113 per cent higher than at the end of January. But the top-performing ETF that month, the ProShares VIX Short-Term Futures ETF (VIXY), returned 40.9 per cent, according to data from National Bank.

“Some may be surprised by the fact that the VIX ETFs only returned less than half of that in February,” Mr. Straus says, a result of the roll risk.

As volatility subsides, some investors may consider trying to recoup losses with inverse volatility ETFs. But portfolio managers have become wary since billions of dollars were lost among traders wagering on continued market stability in 2018.

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The value of the VIX surged suddenly in February, 2018, after a year of historic lows. While the broader market was relatively unscathed at that time, investors betting against volatility saw inverse products plunge.

Considering their complicated structures, costly management fees and high exposure to sudden market swings, these volatility and inverse volatility ETF products are too risky for most investors, according to John Hood, president and portfolio manager at J.C. Hood Investment Counsel Inc.

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