Saturday, November 23, 2013

Should You Invest in a Volatility ETN?

Volatility is one of the most dynamic and misunderstood topics in investing.  There is a lot of interest in the VIX, but most people don’t know how it works.  It is called the best indicator of fear in the market, but that is only because there isn’t a better one.  You can find a good description of how the VIX is calculated, but essentially it is a measure of call and put buying of an instrument, usually the $SPY.   More put buying means a risk of higher volatility, and an increase in the VIX.

Several investment companies, including Proshares and iPath have created volatility ETNs (they operate just like ETFs) and investors can buy and sell them just like stock. 

The problem is that unlike stock, the ETNs lose value over time.  The $VXX, as has been pointed out by Adam Warner (@agwarner on Twitter) has decreased in value from $6,400 to its current price of under $45, a terrible return.  No one should invest in the $VXX for any term longer than a few days.

On the opposite side is an inverse ETN, the $XIV. This product takes advantage of the mechanisms that cause the decay in price of the $VXX.    It has had a 75% return this year on top of similar returns last year.  You will find it hard to get returns like that in any other investment.

Why not just put all your money in the $XIV, or the $SVXY, a similar ETN?

RISK, in all caps.

When volatility does go up, these products get killed.  In 2001, the $XIV was cruising along until the debt ceiling crisis in the summer.  Then it went from $19 on July 1 to a closing low of $4.91 on November 21, a loss of almost 75%. 

Let me repeat that.  A loss of 75% in less than five months. 

Most investors are not going to be able to handle that kind of loss.  Therefore, most investors should stay away from this product, or invest a small amount and watch it carefully for any signs of an increase in market volatility.  It is unlikely you will be able to finance your retirement with this kind of product. 

Professionals love these products because they are useful in hedging positions.  Using them as an investment is asking for trouble.  

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