The one constant on the stock markets is change. Said differently, volatility is a constant companion to investors. Ever since the VIX Index was introduced, with futures and options following later, investors have had the option to trade this measurement of investor sentiment regarding future volatility. At the same time, realizing the generally negative correlation between volatility and stock market performance, many investors have looked to use volatility instruments to hedge their portfolios. (For related reading, check out Getting A VIX on Market Direction.)

Unfortunately, it is not quite that simple and while investors have more alternatives than ever before, there are a lot of drawbacks to the entire class.

Tutorial: Option Volatility

A Flawed Starting Point?
One significant factor in assessing exchange-traded funds (ETFs) and exchange-traded notes (ETNs) tied to VIX is VIX itself. VIX is the ticker symbol that refers to the Chicago Board Options Exchange Market Volatility Index. While often presented as an indicator of stock market volatility (and sometimes called the "Fear Index") that is not entirely accurate.

VIX is a weighted mix of the prices for a blend of S&P 500 index options, from which implied volatility is derived. In plain(er) English, VIX really measures how much people are willing pay to buy or sell the S&P 500, with the more they are willing pay suggesting more uncertainty. This is not the Black Scholes model, in other words, and it really needs to be emphasized that the VIX is all about "implied" volatility.

What's more, while VIX is most often talked about on a spot basis, none of the ETFs or ETNs out there represent spot VIX volatility. Instead, they are collections of futures on the VIX that only roughly approximate the performance of VIX.


A Host of Choices
The largest and most successful VIX product is the iPath S&P 500 VIX Short-Term Futures ETN (NYSE:VXX). This ETN holds a long position in first and second month VIX futures contracts that roll daily. Because there is an insurance premium in longer-dated contracts, the VXX experiences a negative roll yield (basically, that means long-term holders will see a penalty to returns). What's more, because volatility is a mean-reverting phenomenon, VXX often trades higher than it otherwise should during periods of low present volatility (pricing in an expectation of increased volatility) and lower during periods of high present volatility (pricing a return to lower volatility).

The iPath S&P 500 VIX Mid-Term Futures ETN (NYSE:VXZ) is structurally similar to the VXX, but it holds positions in fourth, fifth, sixth and seventh month VIX futures. Accordingly, this is much more a measure of future volatility and it tends to be a much less volatile play on volatility. This ETN typically has an average duration of around five months and that same negative roll yield applies here - if the market is stable and volatility is low, the futures index will lose money. (For more, see Getting A VIX On Market Direction)

For investors looking for more risk, there are more highly leveraged alternatives. The VelocityShares Daily two-times VIX Short-Term ETN (Nasdaq:TVIX) does offer more leverage than the VXX, and that means higher returns when VIX moves up. On the other hand, this ETN has the same negative roll yield problem plus a volatility lag issue - in other words, this is an expensive position to buy-and-hold and even Credit Suisse's own product sheet on TVIX states "if you hold your ETN as a long-term investment, it is likely that you will lose all or a substantial portion of your investment." (For more, see Dissecting Leveraged ETF Returns.)

Nevertheless, there are also ETFs and ETNs for investors looking to play the other side of the volatility coin. The iPath Inverse S&P 500 VIX Short-Term ETN (NYSE:XXV) basically looks to replicate the performance of shorting the VXX, while the VelocityShares Daily Inverse VIX Short-Term ETN (NYSE:XIV) likewise seeks to deliver the performance of going short a weighted average maturity of one month VIX futures.

Beware the Lag
Investors considering these ETFs and ETNs should realize that they are not great proxies for the performance of the spot VIX. In fact, studying recent periods of volatility in the S&P 500 SPDR (NYSE:SPY) and the changes in the spot VIX, the one-month ETN proxies captured about one-quarter to one-half of the daily VIX moves, while the mid-term products did even worse. The TVIX, with its two-times leverage, did better (matching about half to three-quarters of the performance), but consistently provided less than fully two-times the performance of the regular one-month instrument. Moreover, because of the negative roll and volatility lag in that ETN, holding on too long after the periods of volatility started to significantly erode returns.

The Bottom Line
If investors really want to place bets on equity market volatility or use them as hedges, the VIX-related ETF and ETN products are acceptable but highly-flawed instruments. They certainly have a strong convenience aspect to them, as they trade like any other stock. That said, investors looking to really play the volatility game should consider actual VIX options and futures, as well as more advanced options strategies like straddles and strangles on the S&P 500. (For more, see Introducing VIX Options.)

Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!

Related Articles
  1. Mutual Funds & ETFs

    ETF Analysis: United States Brent Oil Fund

    Learn more about the United States Brent Oil exchange-traded fund, the characteristics of the fund and the suitability and recommendations of it.
  2. Mutual Funds & ETFs

    ETF Analysis: ProShares Ultra Bloomberg Crude Oil

    Find out more about the ProShares Ultra Bloomberg Crude Oil ETF, the characteristics of UCO and the suitability and recommendations of UCO for investors.
  3. Mutual Funds & ETFs

    ETF Analysis: iShares MSCI Hong Kong

    Learn about the iShares MSCI Hong Kong fund, which invests in various equities of companies listed on the Hong Kong Stock Exchange.
  4. Mutual Funds & ETFs

    ETF Analysis: Vanguard Small-Cap Growth

    Take a close look at the Vanguard Small-Cap Growth ETF, which focuses on domestic small-cap equities with a fundamental growth strategy.
  5. Mutual Funds & ETFs

    ETF Analysis: First Trust Dorsey Wright Focus 5

    Take a closer look at the First Trust Dorsey Wright Focus 5 ETF, a unique and innovative fund of funds based on momentum and relative strength.
  6. Mutual Funds & ETFs

    ETF Analysis: iShares National AMT-Free Muni Bond

    Take an in-depth look at the iShares National AMT-Free Municipal Bond ETF, a highly diverse and very popular muni bond fund.
  7. Mutual Funds & ETFs

    Top 3 Switzerland ETFs

    Explore detailed analysis and information of the top three Swiss exchange-traded funds that offer exposure to the Swiss equities market.
  8. Stock Analysis

    Net Neutrality: Pros and Cons

    The fight over net neutrality has become an amazing spectacle. But at its core, it's yet another skirmish in cable television's war to remain relevant.
  9. Mutual Funds & ETFs

    7 Best ETF Trading Strategies for Beginners

    Exchange-traded funds are ideal instruments for beginning traders and investors. Learn the seven best strategies for trading ETFs.
  10. Mutual Funds & ETFs

    ETF Analysis: SPDR Dow Jones International RelEst

    Learn how the SPDR Dow Jones International Real Estate exchange-traded fund (ETF) is managed and for whom the ETF is most appropriate.
RELATED TERMS
  1. Equity

    The value of an asset less the value of all liabilities on that ...
  2. Exchange-Traded Fund (ETF)

    A security that tracks an index, a commodity or a basket of assets ...
  3. Exchange-Traded Mutual Funds (ETMF)

    Investopedia explains the definition of exchange-traded mutual ...
  4. Hard-To-Sell Asset

    An asset that is extremely difficult to dispose of either due ...
  5. Sucker Yield

    When an investor has essentially risked all of his capital for ...
  6. Lion economies

    A nickname given to Africa's growing economies.
RELATED FAQS
  1. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  2. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  3. What does a high turnover ratio signify for an investment fund?

    If an investment fund has a high turnover ratio, it indicates it replaces most or all of its holdings over a one-year period. ... Read Full Answer >>
  4. Does index trading increase market vulnerability?

    The rise of index trading may increase the overall vulnerability of the stock market due to increased correlations between ... Read Full Answer >>
  5. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  6. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>

You May Also Like

COMPANIES IN THIS ARTICLE
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!