Volatility index ETFs and ETNs: Understanding the risks

Open full sized image

This complex instrument is not for the buy-and-hold investor.

© Morrison1977––iStock/Getty Images

In the world of exchange-traded funds (ETFs), there’s one (or more) for pretty much any sector, industry, subgroup, or strategy you can think of. But just because there’s an ETF for every situation doesn’t mean there’s something suitable for every buyer.

Case in point: volatility index ETFs. They’re designed—in theory, anyway—to help investors monitor and hedge against wild fluctuations in the stock market. But these are complex instruments that come with their own set of unique risks that match, or even outweigh, the risks in the market itself. Like inverse and leveraged ETFs, volatility ETFs are used tactically for short-term trading and aren’t designed as long-term holdings.

And note: Don’t confuse volatility index ETFs with another type of ETF strategy known as low-volatility ETFs. Those use academic research and fundamental analysis to find stocks with solid, steady returns and reduced risk.

Here’s what you need to know before investing in a volatility index ETF.

Before you can understand the relationship between the stock market, market volatility, and ETFs that attempt to reflect that volatility, it’s important to understand a few market structure basics:

Volatility index ETFs don’t reflect the current VIX index price (which, again, is a measure of volatility expectations based on SPX options set to expire in the next month). Instead, a volatility index ETF reflects the implied volatility of the options that will make up the “30-day maturity window” in the futures contracts that the ETF holds. It’s a derivative made up of future expectations of another derivative.

Is your head spinning yet?

Historically, the dividing line between muted and elevated volatility is 20. The VIX is generally low (in the mid-teens and below) when options traders expect the stock market to be tranquil 30 days out. If they expect big price swings, the VIX will typically rise. A VIX above 30 indicates “extremely high” implied volatility.

Yet the volatility of the VIX and the volatility of the stock market aren’t always in sync. Because options traders are looking a month ahead, they could be worrying about something in the future that sends the VIX higher, while the actual market isn’t moving much. On the other hand, sometimes the stock market sells off hard, but the VIX stays muted because options traders aren’t worried about what might happen next month.

In other words, if you’re trying to offset the risk in your stock portfolio, the VIX (and thus any security that’s priced off the VIX) won’t necessarily give you what you need—you’re hedging actual price risk with the market’s expectations of future volatility.

But there’s more.

Pretty much all volatility index ETFs use the VIX futures market for their volatility exposure. Some buy near-term futures contracts; some hold a mixture of short-dated and deferred-month contracts. Regardless of which futures contracts an ETF holds, it must occasionally “roll” those futures positions (that is, sell positions that are about to expire and buy longer-dated contracts). Some roll a portion of their positions every day in order to maintain a constant average maturity in the portfolio; others hold positions longer, then roll into the next contract month before the near-term contract expires.

The problem with this position-rolling activity—regardless of how often—is that, most of the time, the VIX futures curve is in contango, meaning the front-month contract is lower than the second-month contract, which is lower than the third-month contract, and so on. With each roll, the fund is selling low and buying high. That’s why a volatility index ETF isn’t suitable as a long-term hold. See figure 1.

Open full sized image

Figure 1: THAT DANG-O CONTANGO. Every time you roll a futures contract in a contango market, you sell low and buy high—the exact opposite of what traders prefer to do.

Encyclopædia Britannica, Inc.

Although volatility index products are typically called exchange-traded funds (ETFs), most are actually exchange-traded notes (ETNs). And yes, there’s a difference.

An index ETF holds a basket of securities (such as all the stocks in the S&P 500, for example), in a ratio proportional to the underlying index. When you buy into the ETF, you don’t own the stocks per se (e.g., you don’t get voting privileges), but you do hold an ownership stake in the fund that owns the actual securities. You’re entitled to a commensurate share of the dividends the underlying stocks pay, and the performance of the fund is based on the return on actual securities.

An ETN does not hold any securities. It’s a debt instrument held by the issuer (typically guaranteed by a bank), which buys and sells derivative contracts to try to mirror the performance of the underlying index based on a preset (and published) formula. The issuer tracks the profit and loss (P&L) of the positions it holds, and reflects the P&L in the value of the underlying note, in what’s called “indicative value.”

This all sounds complex because it is. And because an ETN is a debt instrument, when you buy shares in one, you assume credit risk. If the issuer were to default on the note, you could lose money—up to the limit of your investment. It’s rare, but it could happen.

ETFs and ETNs have different rules as well. ETFs are governed under the Investment Company Act of 1940, while ETNs typically fall under the Securities Act of 1933. Generally, “40 Act” funds have stronger investor protections, such as having a board of directors that watches for investors’ rights, and they have more governance oversight than “33 Act” funds.

Volatility indexed exchange-traded products offer investors a liquid way to access a concentrated area of the futures market—one that can experience significant volatility and may or may not reflect what’s going on in equity markets.

Volatility index ETFs are derivatives of derivative products and should be used with care. But there’s another type of investment that targets stocks with low volatility. Despite having the same word in the description, low-volatility ETFs are very different.

Low-volatility stocks tend to have fewer price swings over time compared to the broader market. Academic research shows that many low-volatility securities can outperform similar, riskier securities over time. For example, one test of the capital asset pricing model (CAPM) between 1940 and 2023 showed that buying low-volatility stocks and selling high-volatility stocks produced 6.3% more in alpha (that is, return above the broader market).

Low volatility is one of a handful of market factors used in so-called “smart beta” ETFs—products that use quantitative research to screen and weight stocks in ways that aren’t based on traditional market-capitalization weightings (such as the S&P 500).

Low volatility is considered a risk-based factor, since a fund issuer using it as a criterion will be weighting stocks based on their historical volatility. Fund issuers often pair factors together to attempt to improve investor experience. For example, sometimes the low-volatility factor is combined with high dividends as another way to reduce risk in a stock portfolio geared toward income generation. Thus, the low-volatility risk factor is teamed with a “quality factor”—such as high dividend yield or a strong balance sheet (i.e., low debt and multiple sources of liquidity)—as a way to try to improve risk-adjusted returns for the ETF.

Volatility index ETFs are designed for short-term, tactical trading, and because they are based on futures contracts, the return on these ETFs is often chipped away if an investor holds them for a long time. Investors interested in buying volatility ETFs should have a specific reason, as well as an exit target in mind (for better or worse). These are not long-term, buy-and-hold investments.

Investors should not confuse volatility ETFs with smart beta ETFs that use low-volatility factors to weigh portfolio holdings. These are two separate strategies. And before you jump into any investment, do your homework (i.e., due diligence) to make sure it falls within your objectives and risk tolerance.