Beware of VIX ETFs and ETNs

One of the best performing assets so far this year have been short-term exchange-traded funds (ETFs) and notes (ETN) based on the Cboe Volatility Index (VIX), which rises when volatility in the S&P 500 index increases.

The index represents the market's real-time expectations for the relative strength of near-term price changes of the S&P 500 index. The exchange-traded products invest in futures contracts that track the VIX; investors cannot buy the VIX directly.

As the stock market reversed course and traded lower in January, the ProShares VIX Short-Term Futures ETF (VIXY) and the iPath Series B S&P 500 VIX Short-Term Futures ETN from Barclays (VXX) soared, gaining more than 30% through Jan. 27.

Both track the VIX futures, not the spot price of the VIX index, providing exposure to a daily rolling long position in the first and second month S&P 500 VIX futures contracts.

Their longer-term counterparts, the ProShares VIX Mid-Term Futures ETF (VIXM) and iPath B S&P 500 VIX Mid-Term Futures ETN (VXZ), which have exposure to Cboe Volatility Index futures with an average five-month exposure, didn't fare as well. They gained between 5.3% and 5.9% year to date through Jan. 27. The S&P 500, meanwhile has fallen more than 9%, teetering on the edge of correction territory.

Short- and medium-term ETPs performed especially poorly last year, when the S&P 500 soared almost 27%, but posted gains around 10% in 2020 when stocks swooned early on when the coronavirus pandemic began to spread.

Short- and medium-term VIX ETPs have been on the market for a dozen years, but their total assets today are just $2.5 billion, despite total net inflows of $14.9 billion through Jan. 26, according to Ben Johnson, director of global exchange-traded fund research for Morningstar.

"VIX-linked ETPs have effectively destroyed $12.4 billion in capital during nearly 12 years since they debuted," he said. "Investors should steer clear."

The Risks of VIX ETFs and ETNs

Instead of protecting investor assets against losses, VIX-linked ETPs have, overall, added losses to investor portfolios. A primary reason is the fact that these investments don't invest in the actual VIX index but in a futures contract based on that index.

Since the futures curve is in contango — later-month contracts cost more than current-month contracts — investors who roll over their contract into the next future month lose money on the transaction.

"Regularly selling current contracts low and buying subsequent contracts high results in negative roll yield," Johnson said.

"VIX funds are not investment long-term instruments," says Michael Iachini, head of manager research at Charles Schwab Investment Advisory. "Most investors need to really understand what the futures curve is … before they consider investing in a VIX-related fund."

Complicating these investments is also their structure. VIX funds — and there are far more than the ones mentioned in this article — include ETFs like the ProShares vehicles that many investors are familiar with.

Others are exchange-traded notes, which tend to be less well-known. They are essentially debt instruments from a bank and therefore can involve credit risk (of the bank). These different structures are also subject to different tax treatments.

Moreover, if they're held for the short term and appreciate in value, they will be subject to short-term capital gains tax, which is equivalent to an investor's income tax rate. Fees for VIX ETPs are also high, topping 90 basis points.

These ETPs are "too expensive to use due to [potential] long-run erosion of value," said Iachini, adding that they are speculative products, which most advisors are generally not interested in. He recommends that instead of VIX ETPs advisors protect client assets the tried-and-true way – with asset allocation, maybe some cash. VIX ETFs are not a "magic bullet to erase market risk."

Shorting the VIX

The VIX is now retreating after seven consecutive days of increases, which presents another short-term investment opportunity for some investors: shorting the index, which can be done with inverse VIX ETPs.

According to Bloomberg there have been only 10 times in the past two decades that the VIX has fallen for seven trading days in a row. After nine of those times, investors who shorted the VIX earned nearly 19% after 20 days, Bloomberg reported.