The world of exchange-traded funds (ETFs) and similar products has grown so large and particular that one can find multiple investment vehicles for just about any bet related to the markets. In some cases, ETFs have a broad mandate, such as an entire sector or even a large index of names. In other cases, the focus of the exchange-traded product can be narrow and esoteric. Exchange-traded products that rise along with the Cboe Volatility Index (VIX) likely fall within the latter category. In recent weeks, these products have proven to be highly lucrative as Wall Street fear levels have grown.
The Difficult Month of October
A report by ETF.com notes that from, Oct. 1 through Oct. 29 of 2018, the S&P 500 dropped by more than 9%. In turn, the VIX, which represents implied volatility, climbed to its highest levels since April. With a VIX level of 25, ETFs making bets on volatility surged ahead. For that same period, the iPath S&P 500 VIX Short-Term Futures ETN (VXX), which stands as the largest product of this type with more than $1 billion in assets under management (AUM), climbed by a whopping 50% or more.
Other related products ballooned by even larger percentages: the VelocityShares Daily 2X VIX Short-Term ETN (TVIX) more than doubled over this period thanks to its use of leverage. However, within the broader context of a large-scale decline across 2018, TVIX has so far not been able to generate positive returns year to date.
It's important to note that these two products have both given up much of their gains from October as of this writing. TVIX has retained a one-month gain of more than 20%, while VXX has seen gains closer to 15% as of this writing.
How ETFs Track the VIX
The VIX is seen as a barometer of investor concern. Because it typically rises when stocks dip and falls when stocks increase in price, it is often called a "fear gauge" for the market. However, an exchange-traded product cannot directly track movement in the VIX itself. The reason for this is that the portfolio that the VIX tracks is changing all the time.
Instead, VIX futures allow investors to make bets on how the VIX will shift over time. Investors believing that the VIX will move lower (or that stocks will rise) looking forward can seek to profit off of their estimations in the VIX futures space. Exchange-traded products that are related to the VIX typically engage with the volatility index in this secondary way – by packaging groups of VIX futures into larger products. Therefore, while an ETF may not track the VIX exactly, it does tend to move alongside VIX futures, which also tend to converge with the VIX the closer that a futures contract gets to expiration.
Implications for Investors
Investors interested in getting involved in the complex world of VIX exchange-traded products would do well to recognize that these investment vehicles are best used for short-term, tactical investments. Because the VIX and exchange-traded products that aim to track it tend to shift dramatically and frequently, these products are usually not seen as viable long-term investments.
Part of the reason for this timeframe also has to do with a concept known as contango. Contango refers to a scenario in which the price of a futures contract is above the expected spot price. VIX exchange-traded products that roll positions from futures contract to futures contract often must sell their contracts at a lower price, only to buy at a higher price. Thus, these products tend to take a loss as a result of cumulatively growing roll costs that increase over time. Nonetheless, as recent weeks have shown, investors timing their decisions carefully can make significant profits in this space.