Caveat Emptor – Volatility ETFs
May 2nd 2012 at 3:21pm by John Spence
Every few months a major news outlet will run a story on how some investors lost money because they didn’t understand how contango affects exchange traded products designed to track futures contracts.
Although some of these products are very complex, it could also be argued that investors who don’t do their homework deserve at least some of the blame. The bottom line for investors is that it’s always important to fully understand a fund before the purchase.
On Wednesday, Bloomberg News told the story of 34-year-old pilot and day trader Ian Mathers, who says he “got burned” by a Barclays exchange traded note, iPath S&P 500 VIX Short-Term Futures ETN (NYSEArca: VXX).
“Mathers bought the Barclays note expecting it to move in lock-step with spot VIX,” Bloomberg reported. “Instead, the note tracks futures contracts, which means it won’t necessarily match the performance of that gauge.”
Volatility-linked products can be hurt by contango in futures markets, when later-month contracts are more expensive than the current contract. Some commodity ETFs are also susceptible to this condition in futures markets.
The prospectus for VXX warns contango can hurt the ETN and result in negative “roll yields.”
VXX is trading near its 52-week low as a falling VIX suggests investors are less fearful about a potential correction in stocks. [Volatility Shunned as VIX ETN Nears One-Year Low]
VXX is the largest volatility exchange traded product with a market cap of about $1.8 billion. It is structured as an ETN, although there are also ETFs designed to follow VIX futures, such as ProShares VIX Short-Term Futures ETF (NYSEArca: VIXY).
ETNs are debt instruments issued by financial institutions that promise to pay the return of an index, minus fees and taxes. They involve credit risks that aren’t associated with ETFs, shares of which represent a slice of a portfolio of assets.
VXX is down 55% year to date, according to Morningstar.
The Bloomberg story comes in the wake of last month’s plunge in VelocityShares Daily 2x VIX Short-Term ETN (NYSEArca: TVIX), a leveraged fund. [Banks Fined Over Leveraged and Inverse ETF Sales]
The SEC is probing the ETN’s swift decline that occurred when its premium collapsed. [SEC Reviewing TVIX Flop]
About 30 volatility products have been listed since January 2009, according to the article. Some traders use them to speculate on market declines or hedge. They’re designed as trading vehicles rather than buy-and-hold investments.
Inexperienced traders looking to make a “quick buck” are behind some of the demand for volatility notes, said Bill Luby, founder of the VIX and More blog, in the Bloomberg story. These investors “are probably not sophisticated enough to buy options,” Luby added.
iPath S&P 500 VIX Short-Term Futures ETN
The opinions and forecasts expressed herein are solely those of John Spence, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.