Volatility Investing
Exchange-traded products (ETPs)—including exchange-traded funds (ETFs), (ETNs), and commodity and currency ETPs—have surged in popularity over the last decade. Since the launch of the first U.S.-based exchange traded fund in 1993, the number and market value of ETPs in the U.S. have grown substantially, with thousands of products now representing trillions of dollars in value.
ETPs are listed on exchanges and trade like stocks. They come in a variety of asset classes such as stock, bond and commodity ETPs. They also employ various strategies to achieve return on investment including hedging, the use of futures, taking positions in alternative investments such as crypto assets, and leveraged and inverse strategies.
Easy as it is to trade ETPs, risks vary for each product, with some types of ETPs exposing investors to both complexity and significant danger of losses. Volatility-linked ETPs are one such example. If you’re seeking to profit from price swings (volatility), you now have a number of products that allow you to do so. But with opportunity for gain also comes potential for loss.
Understanding the VIX
A variety of volatility-linked ETPs exist. The most basic offer long exposure to the Cboe Volatility Index (VIX). The VIX is not based on actual price fluctuations experienced on a given day (or over some other timeframe) but instead reflects an expectation of stock market volatility over the next 30 days as implied by S&P 500 Index options prices.
Crucially, the VIX itself is not investible. You’d generally obtain exposure to volatility using VIX futures or other derivatives. For this reason, volatility-linked ETPs tend to track or are linked to VIX futures. While VIX futures prices are generally highly correlated with movements in the VIX, they don’t track it precisely, and their degree of correlation can depend on the maturity date. The price "sensitivity" of VIX futures to the underlying VIX may be quite a bit less than you might expect, and this sensitivity generally gets weaker the farther out the futures go.
What makes the idea of volatility investing tied to the VIX potentially attractive to investors is that the VIX historically has been negatively correlated with stocks—that is, it often moves in the opposite direction of stocks, in particular moving sharply higher when stock indices decline significantly. This feature has made it a potential tool to hedge stock market performance, and for this reason it's often referred to as the market's “fear gauge.”
Know What You’re Investing In
Volatility ETPs tend to offer tactical hedges against, or speculative positions on, movements in the VIX. But there are also inverse and leveraged volatility ETPs. An inverse ETP generally seeks to deliver the opposite of the performance of a specified index over a given time period. Meanwhile, a leveraged ETP generally seeks to deliver multiples of the performance of an index over a given time period.
Regardless of the type or complexity, volatility ETPs generally aren’t designed to be used as buy-and-hold investments—and while they can generate eye-popping gains, they can also quickly lose some or all of their value in a very short time. This risk can be amplified if you buy them on margin.
Virtually all volatility-linked ETPs are complex, and their strategies and objectives can vary from product to product. If you’re seriously considering investing, read the product’s prospectus—the whole thing—and read the information about risks twice.
In the end, volatility can seem like an interesting asset class, but keep in mind that not all volatility-linked ETPs carry the same degree of risk. It's important that you understand these risks—and the products themselves—before you invest.
