Investing in volatility can be tricky business. A look at where money has been flowing when it comes to the volatility trade shows that nearly $2 billion in fresh net assets have gone into two of the most popular volatility ETFs this year, the iPath S&P 500 VIX Short-Term Futures ETN (VXX) and the ProShares Ultra VIX Short-Term Futures ETF (UVXY).

The flip side of this trade, inverse volatility ETFs, have generally been net asset losers, with strategies like the VelocityShares Daily Inverse VIX Short-Term ETN (XIV)—the largest volatility exchange-traded product, with $1.1 billion in total assets—and the REX VolMAXX Short VIX Weekly Futures Strategy ETF (VMIN)—facing some $180 million in combined net redemptions.

What’s interesting here is the performance of these volatility strategies. Year-to-date, it’s the inverse funds that are riding higher, and specifically, it’s the relatively young VMIN—the small ETF with only $13 million in total assets, and a pretty expensive strategy costing 3.13% in expense ratio—that’s leading the pack with a performance so stellar no other volatility strategy has been able to match.

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Chart courtesy of StockCharts.com

VMIN is a unique fund, achieving that inverse exposure by shortening the term of the VIX futures it holds—it owns VIX futures with less than 30 days to expiration. By comparison, other short-term volatility products often rely on monthly contracts. And VMIN is actively managed. Greg King, founder of REX ETFs, and former co-founder of VelocityShares, gives us a run-down on how VMIN works, and what investors can expect from volatility investing. (For related reading, see: Managing Client Expectations in a Volatile Environment.)

ETF.com: Are you surprised by this year's record low volatility?

Greg King: What's surprising is how long the low volatility environment has persisted. It's been around for quite a while, and the volatility spike that we saw around election time last year was extremely short-lived. I think a lot of people thought the outcome of the election might lead to a more persistent, higher-volatility regime. So it’s surprising how long it's lasted.

I'm not surprised that it's here, though. There are a lot of volatility-selling strategies out there, and there are some macroeconomic factors that continue to dampen volatility.

ETF.com: Is timing everything when it comes to investing in volatility products?

King: Yes to all of the above. Investors who are trading volatility products need to have a very good handle on how the markets are moving on a daily and even intraday basis. There are clearly better times than others to go long or short volatility. So there's a significant timing element to it.

We have seen an increase in the number of investors who are talking about maintaining longer-term positions that are short volatility in an effort to capture some premium. But keeping tabs on what you’re doing at all times is key.

ETF.com: Generally speaking, are volatility ETFs used more for speculation or for hedging?

King: I think it's a fair amount of speculation for capital appreciation purposes, but also a fair amount of hedging. But portfolio hedging can be a speculative exercise itself. Often investors don't have hedges on until they feel the timing might be right to put a hedge on. Perhaps it would be better to say these investment products are typically used in a tactical way.

ETF.com: Let's talk about your volatility ETFs

The inverse VMIN is up 148% this year, while the REX VolMAXX Long VIX Weekly Futures Strategy ETF (VMAX) is down 76%. In simple terms here, how do these products work?

King: Generally, our funds hold a basket of exposures to VIX. And they do so using a combination of weekly and monthly futures, as well as some exposures to other ETPs. In general, our “duration”—the average time to maturity of VIX futures' exposure—is somewhere in the low 20s in terms of number of days. It's a three- to four-week exposure.

What that means in the short fund, VMIN, is that, generally speaking, the fund is exposed to a part of the curve that's a little bit closer to spot than the benchmark index, the S&P VIX monthly futures index. That exposure is generally at a point in the curve that’s a little bit steeper. So that position will have a little bit higher beta to movements in spot VIX, according to research done by Cboe.

ETF.com: VMIN is a short fund, but it's not inverse to VIX spot itself, right?

King: Correct. Remember, these are rolling futures positions, so every day that goes by, it gets a little closer to expiring the futures contract. At some point, it needs to be rolled into the next future contract. When the curve is upward sloping, the price of the next future is higher. In this case, a short strategy will be selling high and buying low. This means that position will, all other things being equal, make money.

Conversely, a long position will tend to buy high and sell low, meaning, all other things equal, it’ll lose money. However, spikes in volatility can offset short volatility gains and long volatility losses, sometimes extremely quickly. (For more, see: Volatility: How Advisors Can Help Clients Stomach It.)

ETF.com: Why is a shorter time horizon a better mousetrap than what other ETFs are doing?

One of the distinguishing factors of your strategies versus other volatility products is that you focus on shorter-term VIX futures than what other strategies do.

King: The idea behind getting closer to expiry with the contracts is so that they will have a truer exposure to spot VIX. It's pretty much impossible to simply hold a position in spot VIX; it's a theoretical number. But futures contracts with one day left to expiry, for example, tend to track the movements of spot VIX very, very closely, because in one day's time, that's what's going to be due under the contract.

Whereas, if you can imagine a contract that still has six months left to settle, the movements of spot VIX and the movements of that contract can be very different. And that contract tends to be, in general, pretty muted with respect to its responsiveness to spot VIX.

If the idea is to try and get something that bears as much similarity as possible to spot VIX, then it's logical to move down the curve and closer toward spot VIX.

ETF.com: Is there a point where investors and traders should think about cashing in on short-volatility products for long-volatility products?

King: Those points come all the time. And they're different for each investor. We’ve heard of many different strategies in terms of how investors decide when to make those decisions. Obviously, it's not our place to tell them what to do. But these products are very actively traded as an overall complex. I will say we’ve seen a lot of people expecting volatility to spike and continuing to be disappointed.

ETF.com: Do investors express concern about lack of liquidity in VMIN and VMAX relative to competitors?

King: These products were created to add a few things to the existing offerings out there. First of all, they’re ’40 Act Funds, so you have a portfolio manager who’s looking to implement the strategy in a way that's optimal. Secondly, there’s some flexibility. They're not just index-tracking products, so they have flexibility to roll the contracts in a smart way. Third, we have closer exposure to spot VIX.

Our relative liquidity is, of course, something that we're continually working on with market makers and the CBOE to improve. But we see demand for our products increasing over time, especially as they continue to prove themselves to meet their objectives well.

ETF.com: Any misconceptions people have about volatility ETFs?

King: When it comes to shorting VIX, one of the misconceptions out there is that, to take a position that is short volatility means someone has to believe volatility's going to go down in order to profit. That's not the case.

Historically, the majority of the returns associated with a short-volatility position actually come from holding that position during a time when the curve was steep, which is generally the case, and not from VIX actually falling. That's why you see VMIN’s performance recently continuing to be positive even though VIX levels are already very low.

Contact Cinthia Murphy at cmurphy@etf.com. To get the latest ETF news in your inbox, sign up for the ETF.com Daily Newsletter.

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