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The CBOE Volatility Index is considered Wall Street’s favourite fear gauge.MICHAEL HIRTZER/Reuters

Many investors are worried that markets could drop dramatically given their lofty valuations and threats, including rising interest rates and another potential wave of the coronavirus.

But you wouldn’t know it from following the VIX.

The VIX, formally known as the CBOE Volatility Index, is a real-time measure of expected market volatility in S&P 500 index options in the next 30 days. It’s considered Wall Street’s favourite fear gauge.

The VIX is currently sitting around 18 and has been within its long-term average of between 15 and 20 since May, suggesting there’s nothing to fret over. The number is calculated through a complicated formula, with lower numbers indicating lower volatility.

Still, market watchers caution investors on using the VIX to make long-term or even medium-term decisions in their portfolios.

“I think it’s a good indication of the volatility market participants see at the current moment, but it’s by no means a guarantee of what volatility will occur in the future,” says Chris Heakes, a portfolio manager at BMO Global Asset Management.

He points to mid-February, 2020, when the VIX was sitting slightly below its average before suddenly spiking up, eventually reaching a record of 82.7 on March 16 last year. That beat its last high of 80.9 on Nov. 20, 2008, during the global financial crisis.

“The caution for investors is believing that it will be a quiet summer because the VIX is around 16,” Mr. Heakes says. “It’s the wrong way to look at it.”

For investors interested in playing the VIX, either directly or indirectly, there are correlated exchange-traded funds or the use of covered call options.

Mr. Heakes says BMO has a handful of covered call ETFs that he argues are a less risky way to “monetize the VIX” compared with more direct VIX-related ETFs.

With the covered call products, investors have a right to purchase the underlying stock at a predetermined price (known as the strike price) over a specific period. On the flip side, the seller of the call option must sell the stock to the buyer at the stated strike price.

“Volatility is the most meaningful input to the price of an option. So, therefore, when VIX is higher, these options carry a little bit higher premiums. So, it could be advantageous,” Mr. Heakes argues.

Horizons ETFs Management (Canada) Inc. offers the Betapro S&P 500 VIX Short-Term Futures ETF (HUV-T), the only VIX ETF offering in Canada, which provides single-long daily exposure to the VIX index. (Horizons closed two of its other volatility ETFs in April, 2018, weeks after volatility futures contracts spiked by more than 100 per cent during one 24-hour trading period, stating at the time that they “no longer offer an acceptable risk/reward trade-off for investors.”

Nick Piquard, a portfolio manager at Horizons and VIX expert, says HUV is similar to owning puts for downside protection but sees it as less onerous.

“What I like about owning this product versus buying puts is that, with puts, you’ve got to pick a strike price ... an expiry date, and you trade options, which not everyone can do ... and you have to buy it every month or quarter,” he says. “With [the HUV ETF], it’s like buying a stock; you just buy this volatility hedge and if it goes up you can make some money.”

Still, he acknowledges it’s a risky product that’s better suited to more experienced, short-term investors looking for protection if they believe markets are set to drop.

HUV, which has a management expense ratio of 1 per cent, is down 55 per cent so far this year, as of July 9, but was up 14 per cent in 2020, according to Morningstar data. Mr. Piquard also points out HUV soared by more than 300 per cent from the start of January, 2020, until the VIX hit its peak in mid-March.

Jason Del Vicario, a portfolio manager at Hillside Wealth Management, a division of iA Private Wealth, says even short-term investors trying to play the VIX are taking a huge risk since it can move quickly in either direction. Also, he says investors should be mindful of the tracking errors that can often occur with funds following a synthetic index.

“I’ve tried in the past to find some way of buying it,” he says of VIX-related products, “but I just haven’t found a way, in terms of managing money for the retail investor, to gain that exposure for our clients in a way where fees and tracking errors don’t really eat into the returns.”

Dan Hallett, vice-president of research with HighView Financial Group in Oakville, Ont., says VIX-related products are too risky for many investors and believes the index itself should be viewed more for interest than strategy.

“I just don’t see how people can make practical use out of it. … I think investors’ time can be better spent on other activities that will leave them better off in the long run.”