Volatility ETFs have their uses and users, but just how do they work?
The presence of regularly occurring anomalies in conventional economic theory led to the development of the field of behavioral finance, and the volatility anomaly is one that deserves some special attention.
Anomalies directly violate modern financial and economic theories, which assume rational and logical behavior. We now have a laundry list of anomalies, including momentum and the poor performance of stocks that exhibit lotterylike distributions—initial public offerings, penny stocks, small-growth stocks and stocks in bankruptcy.
But, as I said, there’s another anomaly that belongs on the list—the popularity of volatility-based investment products.
Exchange-traded products (ETPs) linked to the CBOE Market Volatility Index (VIX) were launched in January 2009. There are now more than 30 ETPs with a market value of about $4 billion, generating daily trading volume in excess of $800 million.
You might wonder why there’s all this interest, when the March 23, 2012 prospectus of VelocityShares, the exchange-traded notes (ETN) issued by Credit Suisse AG states: “The long term expected value of your ETNs is zero. If you hold your ETNs as a long- term investment, it is likely that you will lose all or a substantial portion of your investment.”
In case anyone didn’t know, these securities are not suitable buy-and-hold investments.
So what explains the all the interest in these products? Why are they so popular? We know why the purveyors of the products create them—the annual fees range from 0.85 to 1.65 percent, or $85 to $165 for each $10,000 invested—but why do investors purchase them when they’re more or less guaranteed to lose money over time?
Robert Whaley, author of the paper “Trading Volatility: At What Cost?,” sought the answers to those questions.
Before digging into the findings, it’s important to understand that ETPs are not investments in the Chicago Board of Exchange (CBOE) volatility index called the VIX, which was launched in 1993.
As Whaley explains: “The VIX itself isn’t a traded security. VIX ETPs are traded securities created from complicated VIX futures trading strategies which demand daily rebalancing and are subject to a host of management fees and expenses including futures commissions and trading fees, licensing fees, and, in some cases, foregone interest income.”