Volatility ETPs: A Poor Choice for Hedging, Long-Term Investing

Note: This article is part of the ETF Trends Strategist Channel

By Marc Odo

Synopsis: If one wishes to profit from market volatility, it is unfortunately much easier said than done. It is especially very difficult to capitalize on market volatility using volatility ETPs for the following reasons:

By using futures on VIX, most volatility ETPs are subject to massive downward price pressure due to contango
Passively managed volatility ETPs are not designed to react to changing market conditions
Variance drain is quite detrimental to long-term returns

Although the S&P 500 was up a modest 3.84% in the first half of the year, it’s been a bit of a wild ride. The first quarter of 2016 was the first time since 1933 that the market had a sell off of double-digits and yet still finished in the black at quarter-end. The second quarter will be remembered for the wild market gyrations following the “Brexit” vote. With numerous significant events looming on the calendar, there’s likely just one thing that bulls and bears can agree upon: it’s going to be volatile.

So the shrewd investor might try to capitalize on the increased market volatility. Indeed, some investors treat “volatility” as a distinct asset class. There are close to two dozen ETPs in the Morningstar database that attempt to capitalize on volatility in some shape or form, up from zero in 2009. This category includes long volatility and short volatility strategies, leveraged and unleveraged, ETNs and ETFs, and has an aggregate AUM of around $4.5 billion. They are used as hedging vehicles as well as speculative plays.

While betting on volatility might seem like a bright idea, the unfortunate reality is the long-term performance of volatility-based ETPs has been atrocious. The average return in the volatility category over the first six months of 2016 has been -17.63%. Over the last three years the averages have been -23.87% (2015), -20.50% (2014) and -21.30% (2013). Why is this?

A lot of the problem stems from the fact that most of these products are based on VIX futures, or futures on the CBOE Volatility Index. But just what exactly is the VIX? A lot of people commonly refer to the VIX as the “fear gauge” but that description leaves a lot to be desired. What is VIX actually measuring? How is it calculated?

When you get down to it, the VIX is calculated by inferring the implied volatility of the S&P 500, using the prices of a basket of puts and calls on the S&P 500 as an indicator of market expectations for future volatility. While from an academic standpoint there is some logic to inferring future volatility from option prices, from a practical standpoint the VIX is not an investable index. Unlike a standard stock index where one can simply purchase and hold the stocks in the proper weights, no one has yet devised a way to directly buy the VIX.