Inverse Volatility ETF

What Is an Inverse Volatility ETF?

An inverse volatility exchange-traded fund (ETF) is a financial product that allows investors to gain exposure to volatility, and thus hedge against portfolio risk, without having to buy options. 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.

How Inverse Volatility ETFs Works

Security prices are seldom dormant. Often, all it takes is a small nugget of information for valuations to scurry either upwards or downwards. These movements, commonly referred to as volatility, provide liquidity and enable investors to make a profit. They are also more common in some assets than others. A highly volatile security hits new highs and lows quickly and generally moves erratically. A low-volatility security, on the other hand, is one whose price remains relatively stable.

Inverse volatility ETFs often use the Cboe Volatility Index, or VIX, as their benchmark. When investor confidence is high, indexes such as the VIX, the so-called “fear index” that’s designed to gauge investors’ perception of how risky the S&P 500 Index is, show low numbers. If investors, on the other hand, think that stock prices will fall or that economic conditions will worsen, the index value increases. 

Indices such as the VIX cannot be invested in directly, so it is necessary to use derivatives to capture their performance. In the case of an inverse volatility ETF that tracks the VIX, managers short VIX futures so that the daily return is -1 times the return of the index. Managers want a 1% decline in the VIX to result in a 1% increase in the ETF. In other words, the ETF loses some value if the futures sold increase, and gain if they do not.

If the index that an inverse volatility ETF tracks rises 100% in one day, the value of the ETF could be entirely wiped out, depending on how closely it tracked the index. Some tracking error is common as these ETFs don’t fully replicate the negative return on an index, but rather the negative of the return on a blend of its short-term futures.

History of Inverse Volatility ETFs

Inverse volatility ETFs were 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 gross domestic product (GDP) growth, and low levels of inflation.

A period of relative calm in the stock market turned out to be a blessing for inverse volatility ETF investors. The year 2017 was particularly rewarding, with some of these products achieving returns in excess of 50%.

Then Feb. 5, 2018, came along. Having been at extremely low levels, the VIX suddenly sprung back to life that day, rallying by over 110%. Investors who purchased inverse volatility ETFs the previous Friday saw most of the value disappear, as they were betting that volatility would go down not up.

Criticism of Inverse Volatility ETFs

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 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 pitfall is that these funds tend to be actively managed. ETFs that have an individual or team making decisions on underlying portfolio allocation cost more to run than their passive counterparts. Higher operating expenses reduce the fund's assets and, as a consequence, investors’ returns.

Complexity can also be an issue. Products based on volatility securitization are far from vanilla and are generally 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.

Finally, it’s worth pointing out that most conventional investments theoretically have unlimited upside potential, leaving inverse ETFs at risk of a complete loss of value.