Volatility ETFs are Too Volatile

Volatility ETFs are Too Volatile

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Looking for an investment to protect you against sharp market downturns? How about these seven securities that have been around for the last five years?:

Symbol                    Name      YTD    5 Years
   VXXiPath S&P 500 VIX Short-  -53.27%  -98.36%
Term Futures ETN
   VIXYProShares VIX Short-Term  -53.40%  -98.36%
Futures ETF
   VIXMProShares VIX Mid-Term  -37.46%  -86.96%
Futures ETF
   VXZiPath S&P 500 VIX Mid-  -37.27%  -86.80%
Term Futures ETN
   VIIXVelocity Shares Daily Long  -53.34%  -98.36%
VIX Short-Term ETN
   XVZiPath S&P 500 Dynamic  -18.02%  -59.95%
   VIIZVelocityShares Daily Long  -37.24%  -86.86%
VIX Medium-Term ETN

The year-to-date (YTD) and 5-year returns are as of August 25th for the seven exchange traded funds (ETFs) with a five-year track record that are included in the 12 ETFS that comprise the Volatility ETF database category on ETFdb.com.  The first, VXX, is by far the most popular, with total assets of $1.4 billion and average volume of 20 million shares. VIXY, the second most traded, has total assets of $197 million and average volume of 1.2 million shares. Both funds are two of the three worst performers in the Volatility ETF database year-to-date and for the last five years.

What is a Volatility ETF?

A volatility ETF is an alternative, or niche, exchange traded fund, or ETF. An ETF, according to Investopedia, is a “marketable security that tracks an index, a commodity, bonds, or a basket of assets like an index fund. Unlike mutual funds, an ETF trades like a common stock on a stock exchange.” Per Investopedia, “ETFs typically have higher daily liquidity and lower fees than mutual fund shares, making them an attractive alternative for individual investors.”

As stated in ETFdb.com, “Volatility ETFs offer exposure to volatility in one form or another. Often referred to as ‘fear’ indicators, these funds tend to move in the opposite direction of the broad market. Thus, these funds are used primarily by traders looking to capitalize on sharp market downturns.”

There are currently 22 U.S. volatility ETFs. The first two, Barclays iPath S&P 500 VIX Short-Term Futures ETN (VXX) and iPath S&P 500 VIX Mid-Term Futures ETN (VXZ), debuted on January 29, 2009, shortly before the March 6, 2009 bottom of the 18-month bear market that began in October, 2007. It’s ironic that there has been only one loss year, 2008, since volatility ETFs were introduced.

Seemingly Appealing Strategy

Investing a portion of one’s portfolio in a volatility ETF would seem to be an appealing strategy given the historical performance of the stock market over the last eight years. Beginning in 2009 when the S&P 500 Index increased 26.5%, there have been eight consecutive years of positive returns, with six of them double-digit between 11.9% and 32.4%. 2017 continues to fare well with the index up 10.6% year-to-date. It has increased 266% since March 6, 2009 as of August 25th.

Barring a significant correction over the next four months, why wouldn’t you purchase a volatility ETF knowing that we’re knocking on the door of nine consecutive years of positive returns? This would seem to be a no-brainer given the fact that negative stock market returns occur once every four years on average and we’ve seen only one loss (2008) in the last 14 years.

Market Timing

Volatility ETFs lose their appeal for most investors when you realize that they’re a market timing play that attempts to predict future market price movements. An investment in one of these ETFs is based on a prediction of a sharp market downturn. Like all market timing strategies, however, achieving a long-term return that exceeds the return you would have realized if you simply did nothing is atypical. The reason for this is that you need to be right on two bets, often in a relatively short period of time.

In order to be successful, volatility ETFs must be purchased before a sudden market downturn and sold before a significant market rebound. Even if the timing of your purchase is correct, which often isn’t the case, you need to ride out the bear market for its duration and sell your volatility ETF before the market begins its recovery.

You can see how easy it is to err on the purchase side by looking at the annual and cumulative returns of the individual ETFs in the Volatility ETFdb.com category over the last five years. Beginning in 2013, after the S&P 500 Index experienced returns of 26.5%, 15.1%, 2.1%, and 16.0% for the previous four years, investors naturally questioned short-term sustainability of positive stock market returns.

Despite the fact that volatility ETFs fared poorly during this period, they were being touted as protection against a likely downturn. Not only didn’t this occur, the S&P 500 Index continued to experience positive returns for the next four years:  32.4%, 13.7%, 1.4%, and 11.9%.

A Risky Retirement Planning Strategy

The excessive downside risk associated with volatility ETFs renders them unsuitable as a prudent investment strategy for most investors. While seemingly appealing when evaluated against the backdrop of the bull market that has raged since 2009, their market timing identity makes them a poor choice for anyone who is planning for retirement or who is already retired. Volatility ETFs are simply too volatile.

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