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Zacks Investment Ideas feature highlights: iPath S&P 500 VIX Short-Term Futures ETN, ProShares Ultra VIX Short-Term Fut ETF and VelocityShares Daily 2x VIX ST ETN

Zacks Equity Research

For Immediate Release

Chicago, IL –May 3, 2013 – Today, Zacks Investment Ideas feature highlights Features: iPath S&P 500 VIX Short-Term Futures ETN (VXX ), ProShares Ultra VIX Short-Term Fut ETF (UVXY) and VelocityShares Daily 2x VIX ST ETN (TVIX).

Why I Hate Volatility ETFs (& Why You Should Too)

When markets start tumbling, investors often turn to hedging strategies for protection. And thanks to the rise of ETFs over the past few years, many look to these funds as an easy, liquid way to buy some peace of mind.

While there is a plethora of options in the inverse and short ETF market, many investors have zeroed in on volatility ETFs and ETNs as their go-to hedging tools. That is because these products generally move higher when markets are slumping, or when fear levels are high about the future.

Furthermore, their gains tend to be pretty big when markets are down, with moves of 4% in a single session not out of the ordinary. Volatility products also allow investors to avoid the rebalancing issues that can impact leveraged ETFs, another reason for their popularity among all stripes of investors (see Volatility ETFs: Three Factors Investors Must Know).

Yet, despite these positives, volatility ETFs and ETNs are actually pretty terrible investments for almost everyone out there. There are a number of issues that make these types of funds and ETNs quite poor over medium and long time frames, suggesting that these should be avoided by all except extremely short-term traders.

Inside Volatility ETFs and ETNs

First, it may be useful to point out how these products are constructed in order to get a better idea of the asset class and how they work. Let’s focus on the most popular volatility ETN on the market, the iPath S&P 500 VIX Short-Term Futures ETN (VXX ).

This note has over $1 billion in assets under management, and sees a truly impressive volume level of over 40 million shares a day. Still, the product is a bit pricey compared to some low cost index funds in the market, charging investors 89 basis points a year in fees.

This ETN, like many other popular volatility products on the market, focuses on the S&P 500 VIX Short-Term Futures Index, better known simply as the VIX, for its exposure. However, this index isn’t exactly easy to understand, as it measures the 30-Day expected volatility of the S&P 500 Index.

The easiest way of looking at the benchmark is that it focuses on near and next-term put and call options on the S&P 500. One could write a whole series of articles on the subject, but the most important item to remember is that the VIX represents the expected movement of the S&P 500 over the next month.

Contango: The enemy of volatility

Based on the above explanation, you might think that a bet on a product like VXX is just simply a prediction that the S&P 500 will be more volatile in the near future, or that at least put/call demand will reflect a broad market assumption of volatility in the coming days and weeks. While this is generally correct, for the volatility ETF and ETN world, there is an important factor that needs to be added on top of this; contango.

Most of the time, the VIX futures market trades in a condition known as ‘contango’, a situation where contracts further along the futures curve are more expensive than front month contracts. This trend can have an enormous impact on volatility ETFs and ETNs, as it can eat away at returns over longer time periods.

That is because volatility ETFs and ETNs like VXX must roll from month to month in order to get new contracts and avoid ‘delivery’. But since the next month contracts are more expensive than current ones, VXX investors face a loss every roll period that the product is in contango (see The Three Biggest Mistakes of ETF Investing).

In fact, current contango levels show that the next month contract is more than 5% pricier than the current month, a pretty big hurdle to overcome on a monthly basis!

This can lead to truly devastating returns over long time periods, and make it all but impossible to make money in volatility investing over the long haul. After all, thanks to this roll feature, VXX is down over 80% while the spot VIX has lost just over 15% of its value in the trailing two year time frame.

Caveat to Volatility ETF investing

This isn’t to say that volatility products can’t be used effectively and for huge gains. Right before the fiscal cliff deal was announced, VIX-based products were surging higher generating massive profits for those who got in at the right time.

In VXX from December 17th 2012 to December 28th 2012, gains came in at about 21% for the time period, while 2x leveraged versions of the product like ProShares Ultra VIX Short-Term Fut ETF (UVXY) or VelocityShares Daily 2x VIX ST ETN (TVIX) added more than 40% in the same time frame. These performances obviously crushed broad markets in a similar period, and helped to give some investors a nice end-of-year boost.

However, as quickly as these gains materialized, they disappeared for many investors.From December 31st 2012 to January 4th 2013, VXX slumped by about 20% and the leveraged ones lost about 40%, erasing any gains that investors had seen in the runup.

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