When it comes to investing, volatility is a critical measure to consider. The Chicago Board Options Exchange (CBOE) is known for its Volatility Index, also called VIX. VIX is generated from the implied volatilities on index options for the S&P 500, and it shows the market's expectation of 30-day volatility. Known also as the "fear index," among other similar names, VIX is commonly used as a measure of investor confidence in the market, or, conversely, as a way of gauging how fearful market participants are that volatility will plague the space. The VIX tends to be largely based on stock market reactions; for instance, when the prices of stocks fall, VIX tends to increase, often to an exaggerated degree.

VIX is an incredibly useful tool for mainstream investors looking to trade in stocks directly. However, investors can also trade based on the VIX in other ways as well. For example, the CBOE offers both VIX options and VIX futures. These allow investors to make wagers based on the volatility index itself, rather than on the changes to individual names it attempts to represent. Because of the large-scale reactions common to the Volatility Index, traders and investors are often interested in trading based on VIX.

It is perhaps unsurprising that there is also a growing field of VIX-linked exchange-traded funds (ETFs). These products are a bit more complex than standard ETFs that track a basket of stocks. However, there are nonetheless compelling reasons to consider VIX ETFs. In doing so, though, investors should pay careful attention to how VIX ETFs work and learn about the potential risks and rewards associated with this subcategory of the ETF space. (See also: 4 Ways to Trade the VIX.)

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What to Watch Out for When Using ETFs in a Portfolio

What is a VIX ETF?

VIX ETFs are a bit of a misnomer. Investors are not able to access the VIX index directly. Rather, VIX ETFs most commonly track VIX futures indexes. This characteristic of VIX ETFs introduces a number of risks that investors should keep in mind and that will be detailed below. It also introduces the opportunity for a variety of different types of products within the VIX ETF category. Furthermore, most VIX ETFs are in fact exchange-traded notes (ETNs), which carry the counterparty risk of issuing banks. This is not typically a major concern for VIX ETF investors.

One of the most popular VIX ETFs is the iPath S&P 500 VIX Short-Term Futures ETN (VXX). This product maintains a long position in first- and second-month VIX futures contracts, which roll daily. VXX tends to trade higher than it would otherwise during periods of low present volatility as a result of the tendency for volatility to revert to the mean.

Inverse VIX ETFs are those that profit from the opposite movement of the VIX. When volatility is high, stock market performance usually goes down; an investment in an inverse volatility ETF can help to protect a portfolio during these highly turbulent times. On the other hand, when the VIX climbed by a massive 115% early in 2018, many products that short futures connected to the VIX were decimated. Indeed, both the VelocityShares Daily Inverse VIX Short-Term ETN and the VelocityShares VIX Short Volatility Hedge ETN shut down in part as a result of this movement. (For more, see: Top 3 Inverse Volatility ETFs.)

One example of a popular inverse VIX ETF is the ProShares Short VIX Short-Term Futures ETF (SVXY). Based on VIX short-term futures as an index benchmark, this ETF provides an 0.5x inverse exposure to the underlying index, meaning that it is not a leveraged ETF. For 2017, SVXY returned a whopping 181.84%. However, just as volatility itself can be highly volatile, so too can VIX ETFs; in 2018 through mid-July, the SVXY product had returned -90.08%.

Other inverse ETFs make use of S&P 500 VIX Mid-Term Futures as an index. Products like the VelocityShares Daily Inverse VIX Medium-Term ETN (ZIV) managed to bring in returns of more than 90% in 2017 thanks to this strategy.

VIX ETF Risks

One issue inherent in VIX ETFs is that the VIX itself is more accurately described as a measure of "implied" volatility, rather than volatility directly. Because it is a weighted mixture of the prices for different S&P 500 index options, VIX measures how much investors are willing to pay in order to be able to buy or sell the S&P 500.

Beyond this, VIX ETFs are known for not being great at mirroring the VIX. One-month ETN proxies captured only about 25% to 50% of daily VIX moves, and mid-term products tend to perform even worse in this respect. The reason for this is that VIX futures indexes (the benchmarks for VIX ETFs) tend to be unsuccessful at emulating the VIX index. (See also: VIX ETFs: Wall Street's Risky Trade on Volatility.)

In addition, VIX ETF positions tend to decay over time as a result of the behavior of the VIX futures curve. As this decay takes place, these ETFs have less money to use to roll into subsequent futures contracts as existing ones expire. As time goes on, this process repeats itself multiple times, and most VIX ETFs end up losing money over the long term.

As the examples above illustrate, VIX ETFs are incredibly finicky. Inverse volatility ETFs experience massive losses when volatility levels in the market spike. This can be so dramatic, in fact, that these ETFs can be virtually annihilated due to a single bad day or period of high volatility. For this reason, inverse volatility ETFs are not an investment for the faint hearted, nor are they an appropriate investment for those without a strong knowledge of how volatility works. Interested investors should carefully consider the personnel managing any inverse volatility product before making an investment. It's also likely a good choice to see investments in inverse VIX ETFs as an opportunity for short-term gains, rather than for long-term buy-and-hold strategies. The volatility of these ETFs is simply too extreme to make them a suitable long-term investment option.

The Bottom Line

Investors interested in the VIX ETF space should consider investing for a short period of perhaps a day. Many of these products are highly liquid, offering excellent opportunities for speculation. VIX ETFs are highly risky, but when traded carefully, they can prove to be lucrative. (For additional reading, check out: How to Day Trade Volatility ETFs.)