Alternatives ETFs: Understanding VIX ETFs

The VIX index attracts traders and investors because it often spikes way up when U.S. equity markets plunge. Known as the fear gauge, the VIX index reflects the market's short-term outlook for stock price volatility as derived from options prices on the S&P 500.

The challenge is that investors just can’t access the VIX index. Period.

VIX ETFs exist, but they actually track VIX futures indexes, which creates two massive challenges:

1. VIX ETFs Don’t Reflect The VIX Index

By any measure, VIX futures indexes—and therefore VIX ETFs—do a lousy job emulating the VIX index. The VIX index is truly uninvestable, and over periods of a month or a year, the return pattern of VIX ETFs will differ radically from that of the VIX index.

2. VIX ETFs Tend To Lose Money—Lots Of It—In The Long Run

VIX ETFs are at the mercy of the VIX futures curve, which they rely upon for their exposure. Because the typical state of the curve is upsloping (in contango), VIX ETFs see their positions decay over time. Decay in their exposure leaves them with less money to roll into the next futures contract when the current one expires. The process then repeats itself, leading to massive double-digit losses over the course of a typical year. These funds almost always lose money long term.

In It For A Minute

In the real world, traders stay in VIX ETFs for one day, not one year. VIX ETFs are emphatically short-term tactical tools used by traders. Products like VXX are incredibly liquid, turning over their entire large AUM in one or two days of trading. Traders speculate with VIX ETFs because they offer the best (or least-worst) means to get at the VIX index in the very short run. So-called “short-term” VIX ETFs offer better one-day sensitivity to the VIX index then do “midterm” VIX ETFs.

It’s A Wrap

VIX ETFs aren’t ETFs in the strictest sense. They come in ETN or commodity pool structures, not as 1940 Act funds. ETNs carry the counterparty risk (usually low) of the issuing banks, while commodity pools issue K-1’s at tax time. Still, these structural issues should likely be the least of your concerns here.

VIX ETFs come in other flavors than the pure-play described above. VIX overlay ETFs hold broad equity positions and an overlay of VIX futures exposure. They aim to limit downside equity risk but either bear or try to minimize the high cost of long-term VIX futures exposure.

Next Up? Alternatives ETFs: Can An ETF Replicate A Hedge Fund?

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