DEFINITION of 'Inverse Volatility ETF'

An inverse volatility ETF is a financial product that allows investors to gain exposure to volatility, and thus hedge against portfolio risk, without having to buy options. Inverse volatility exchange-traded funds (ETFs) are based on the securitization of volatility.

BREAKING DOWN 'Inverse Volatility ETF'

Inverse volatility ETFs often use the CBOE Volatility Index, or VIX, as their benchmark. VIX gauges investors’ perception of how risky the S&P 500 Index is, and is sometimes referred to as the “fear index.” 

When investor confidence is high, indexes like VIX show low numbers. If investors think that stock prices will fall or that economic conditions will worsen, the index value increases.  

Inverse volatility ETF managers use a pool of money to trade futures. In the case of an inverse volatility ETF that tracks the VIX, managers short VIX futures so that the daily return that is -1 times the return of the index.

For example, managers want a 1% decline in the VIX to result in a 1% increase in the ETF. The ETF loses some value if the futures sold increase, and gain if they do not. The ETF is rebalanced at the end of each day, making them more appropriate for investors looking for short-term exposure rather than a long-term position.

There are several downsides to inverse volatility ETFs. One is that they are not as cost-effective when betting against a position over a longer horizon. This is because they rebalance at the end of each day. Investors who want to take an inverse position against a particular index would likely be better off shorting an index fund.

Another downside is that these funds tend to be actively managed, which results in fees that reduce returns. The ETFs are also complex financial products, and investors may not truly understand how they are priced or how marketing conditions will impact them.

Products based on volatility securitization are far from vanilla, with investing in inverse volatility ETFs much more complicated than buying or selling stock. This may not be realized by retail investors, who are unlikely to read a prospectus, let alone understand the complexities of securities and indexing. As long as volatility remains low, investors may see a substantial return, as an inverse volatility ETF is essentially a bet that the market will remain stable.

This type of ETF was introduced to the public at a time when global economies were starting to recover from the 2008 financial crisis. In the United States, the period of economic recovery following the recession featured falling unemployment, steady GDP growth, and low levels of inflation. The S&P 500 Index grew by 90% from 2013 to 2017. Indexes that track volatility, such as VIX, showed that investors were confident in the market. Some inverse volatility ETFs saw returns above 50% in 2017.

Unlike conventional investments, whose value moves in the same direction as the underlying benchmark, inverse products lose value as their benchmarks gain. If the index that an inverse volatility ETF tracks sees a gain of 100% in one day, the value of the ETF could be entirely wiped out depending on how closely the ETF tracked the index. On Monday, February 5, 2018, VIX increased by 116% (it fell back to lower levels the next day). Investors who purchased the ETF the previous Friday saw most of the value disappear, as they were betting that volatility would go down.

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