Volatility ETFs: Everything You Need to Know

Volatility ETFs can be used as a hedge against market volatility, trading opportunities or for portfolio diversification. However, VIX ETFs have unique risks that investors should be aware of before making investment decisions. 

Learn more about ETFs that are designed to profit from market volatility, including the pros and cons of investing in them and how to evaluate volatility funds before buying shares.  

What Is a Volatility ETF?  

A volatility ETF, also known as a VIX ETF or a volatility-linked ETF, is an exchange-traded fund that aims to track the performance of volatility indexes or invest in financial instruments tied to volatility. These ETFs are designed to provide exposure to market volatility as an asset class. 

Volatility, in this context, typically refers to the degree of price fluctuation or uncertainty in the financial markets. It is often measured using the Cboe Volatility Index (VIX), which is commonly referred to as the "fear gauge." The VIX reflects market expectations of near-term volatility derived from options prices on the S&P 500 index. 

How Do Volatility ETFs Work? 

Volatility ETFs use various strategies to provide exposure to volatility. Some volatility ETFs seek to replicate the performance of the VIX itself, while others may use futures contracts, options or other derivatives to achieve their investment objectives. These ETFs may go long or short on volatility, depending on their strategies and market conditions. 

How Do Investors Use Volatility ETFs? 

Investors use volatility ETFs for various purposes. Some traders and investors use them for hedging purposes, aiming to protect their portfolios from potential market downturns or spikes in volatility. Others may use them as speculative tools, attempting to profit from short-term fluctuations in volatility. 

It's important to note that volatility ETFs are complex financial instruments and may involve significant risks. They can experience high levels of price volatility and may not perform as expected due to factors such as contango (when futures prices are higher than spot prices) or backwardation (when futures prices are lower than spot prices) in the volatility futures market. 

Investors considering volatility ETFs should thoroughly understand their investment objectives, strategies, risks and costs. 

Implied Volatility vs Expected Volatility 

Implied volatility and expected volatility are two related concepts used in the context of options trading and pricing. It’s important to understand the difference between these volatility concepts. Here's a brief explanation of each: 

• Implied volatility: Implied volatility represents the market's expectation of future volatility of an underlying asset, as inferred from the prices of options on that asset. Expressed as a percentage, implied volatility reflects the collective sentiment and expectations of market participants regarding potential future price movements of the underlying asset. 
• Expected volatility: Expected volatility refers to an investor's own estimate or prediction of the future volatility of an underlying asset. It is based on an individual's analysis, research or forecasting techniques. Expected volatility is subjective and can vary among different market participants. It is often used to guide investment decisions, such as option trading strategies, risk management or portfolio allocation. 

List of Top Volatility ETFs  

With 13 VIX ETFs traded on the U.S. markets, volatility ETFs have total assets under management of $845.18 million. The average expense ratio is 1.07%.  

Here are some of the top volatility ETFs based on assets under management: 

• iPath Series B S&P 500 VIX Short-Term Futures ETN (VXX): This exchange-traded note (ETN) tracks the performance of the S&P 500 VIX Short-Term Futures Index, providing exposure to short-term VIX futures contracts. With $332.6 million in AUM, VXX is the largest VIX ETF on the market. The expense ratio for VXX is 0.89%. 
• ProShares VIX Short-Term Futures ETF (VIXY): This ETF seeks to replicate the performance of the S&P 500 VIX Short-Term Futures Index in a commodity pool structure, offering unique exposure to short-term VIX futures contracts. VIXY’s AUM is $246.7 million and its expense ratio is 1.05%. 
• VS TRUST 2x Long VIX Futures ETF (UVIX): This volatility ETF offers daily 2x leveraged exposure to short-term VIX futures, designed to capture the implied volatility of the S&P 500 in a commodity pool wrapper. The AUM for UVIX is $104.1 million and its expense ratio is 2.78%. 

Pros & Cons of Volatility ETFs  

Investing in volatility ETFs can offer multiple advantages, such as potential for hedging and portfolio diversification. However, it's crucial to note that investing in volatility ETFs involves inherent risks, including the potential for significant losses and increased volatility. Thus, these unique funds are not suitable for all investors and require careful consideration before buying shares. 

Here are some pros and cons of volatility ETFs to consider: 

Pros of Investing in Volatility ETFs 

• Potential for hedging: Volatility ETFs can be used as a tool for hedging against market downturns. When equity markets experience high volatility or decline, volatility ETFs may see increased prices, potentially offsetting losses in a broader portfolio. 
• Trading opportunities: Volatility ETFs can provide trading opportunities for short-term traders or speculators. These ETFs can experience significant price swings, allowing traders to potentially profit from volatility fluctuations. 
• Portfolio diversification: Adding volatility ETFs to a portfolio can provide diversification benefits, especially if the ETFs have low correlations with other holdings. This can potentially reduce the overall risk of the portfolio. 

Cons of Investing in Volatility ETFs 

• Complex products: Volatility ETFs are complex financial instruments. Their performance can be influenced by various factors such as contango (futures market structure) and the inherent volatility of the VIX itself. Understanding these complexities can be challenging for inexperienced investors. 
• Short-term focus: Volatility ETFs are typically designed for short-term trading or hedging purposes. Holding them for an extended period may lead to tracking error and potentially suboptimal returns. They are not typically intended as long-term investment vehicles. 
• Inverse relationship with equities: Volatility ETFs tend to have an inverse relationship with equity markets. While this can provide a hedge during market downturns, it also means that volatility ETFs may experience losses when markets are stable or trending upward. 
• Decay and costs: Leveraged volatility ETFs can be subject to compounding decay due to their daily rebalancing and the impact of volatility roll costs. Additionally, volatility ETFs often have higher expense ratios compared to traditional equity ETFs. 

How to Evaluate Volatility ETFs  

When evaluating volatility ETFs, there are several key factors to consider, including their objective, underlying index, structure and costs. 

Here's what to look for when choosing volatility ETFs: 

• Understand the objective: Start by understanding the objective of the volatility ETF. Is it designed to track the VIX index or a volatility-related index? Determine if the ETF aligns with your investment goals, whether it's hedging against market downturns, short-term trading or portfolio diversification. 
• Analyze the underlying index: If the volatility ETF tracks an index, examine the methodology and components of the index. Understand how it measures or represents volatility and if it aligns with your expectations. Assess the historical performance and behavior of the underlying index. 
• Review the ETF structure: Consider the ETF's structure, such as whether it is an ETF or an ETN (exchange-traded note). ETNs carry credit risk, as they are unsecured debt instruments. Assess the liquidity and trading volume of the ETF, as higher liquidity generally leads to tighter bid/ask spreads. 
• Expense ratio: Evaluate the expense ratio, which represents the fees charged by the ETF provider for managing the fund. Lower expense ratios can have a positive impact on long-term returns, especially for investors holding the ETF for an extended period. 
• Performance and tracking: Analyze the historical performance of the ETF, comparing it to its benchmark or underlying index. Assess the tracking error, which measures how closely the ETF's performance tracks the index. Lower tracking error indicates better performance alignment. 
• Volatility of the ETF itself: Consider the historical volatility of the ETF. Higher volatility indicates larger price fluctuations and potentially increased risk. Evaluate if the ETF's volatility matches your risk tolerance and investment objectives. 
• Risk factors and investment strategy: Understand the risks associated with the ETF. For example, leveraged volatility ETFs carry additional risks due to the compounding effect and the potential for amplified losses. Assess if the investment strategy aligns with your risk profile. 

Bottom Line 

Volatility ETFs can be effective tools for hedging against market volatility or for portfolio diversification. However, it's important to note that volatility ETFs can be complex and carry unique risks. They are typically designed for short-term trading or hedging purposes and may not be suitable for all investors.  

Additionally, the performance of volatility ETFs can differ from the underlying VIX index due to factors such as roll costs and the structure of the ETF itself. Investors considering volatility ETFs should carefully review the prospectus, understand the risks involved, and consider their investment objectives and risk tolerance before investing.