Know Before You Invest: Volatility-Linked Exchange-Traded Products

Exchange-traded products (ETPs), including exchange-traded funds (ETFs), exchange-traded notes (ETNs) and commodity pools, have surged in popularity over the last few years, with thousands of different options. But as the number of these products soars, it's important to remember not all products carry the same risks. In fact, these products were the subject of a FINRA enforcement action just last week.

Investors could risk major
losses if they trade these
volatility-related products
without fully understanding
how they work.

Since the launch of the first U.S.-based exchange traded fund in 1993, the number of ETPs in the U.S. has grown significantly, with the more than 2,000 different products now representing more than $3.2 trillion of assets according to data from ETF.com.

You can now find products linked to a variety of asset classes from stocks and bonds to currencies and commodities, and even volatility. But as exchange-traded products grow in popularity, it's important for investors to know that though they trade like stocks, their risks can be far more complex. In fact, the risks and complexity can vary greatly from product to product.

Volatility-linked ETPs are one such example of a highly complex group of products. These products are typically designed to track Chicago Board Options Exchange Volatility Index (VIX) futures, rather than the oft-cited CBOE Volatility Index, or VIX, itself.

The VIX estimates expected market volatility over the next 30 days by tracking options linked to the benchmark U.S. S&P 500 stock index. Historically, the VIX tends to be elevated in periods of market distress and lower under normal market conditions, and it often moves sharply higher when stock indices decline significantly. For this reason it's often referred to as the market's “fear gauge.”

The VIX itself is not an investible index, but exposure to volatility is often obtained using VIX futures. VIX futures have a variety of maturity dates, ranging from one week to many months out. VIX futures prices reflect the market expectation of volatility over the 30 days after the VIX future's maturity date.

While VIX futures prices are generally highly correlated with movements in the VIX, they do not track it one-for-one and their degree of correlation can depend on the maturity date. VIX futures price “sensitivity” to the underlying VIX may be quite a bit less than some investors might expect, and this sensitivity generally gets weaker the farther out the futures go.

Investors could risk major losses if they trade volatility-linked ETPs without fully understanding how they work. Some may believe, for example, that the products could be used as a long-term hedge on equity positions in the event of a market downturn. In fact, most volatility-linked ETPs are generally short-term trading products that can degrade significantly over time and are not designed to be used as a long-term buy-and-hold investment.

The key is to understand how the structure of these products differs from many other ETPs. While many exchange-traded funds hold a basket of stocks, most volatility-linked ETPs track indices of VIX futures. Some volatility-linked ETPs—commodity pools and ETFs—may actually buy and sell VIX futures, but volatility-linked ETNs, which are the most common, simply track the indices without making any actual investment.

VIX futures indices usually target a given futures maturity, such as one month, and will rebalance their exposure to futures of different maturities on a frequent basis to maintain that targeted maturity. This rebalancing involves replacing contracts that are nearer to expiring with contracts with maturity dates that are farther out.

The cost of maintaining the targeted exposure by rebalancing futures positions can be high, thus eroding the value of the indices and the ETPs tracking them over time. That's because historically the prices of VIX futures contracts with shorter maturities tend to be lower than those with longer maturities, a characteristic often referred to as contango.

In a market characterized by contango, selling contracts with shorter maturities and lower prices and replacing them with contracts with father-out maturities and higher prices can lead to value erosion. Importantly, while volatility-linked ETPs generally track their indices very well, they are not designed to track the VIX, and performance of these products, especially over longer time periods, can diverge significantly from that of the VIX.

Things can get more complicated than that, with inverse or leveraged volatility-linked ETPs. An inverse ETP generally seeks to deliver the opposite of the performance of a given index over a given time period. Meanwhile, a leveraged ETP generally seeks to deliver multiples of the performance of an index over a given time period.

Moreover, most leveraged or inverse volatility-linked ETPs "reset" every day, which means they are only designed to accomplish the stated leveraged or inverse objective on a daily basis—these ETPs don't make any promises as to how their returns will compare over a longer period, which can make the products risky long-term—or even medium-term—investments.

Leveraged or inverse volatility-linked ETNs carry the same reset risk, but ETNs, which can often be confused with ETFs, also carry their own set of risks. While volatility-linked ETFs and commodity pools are invested in actual VIX futures, volatility-linked ETNs have no underlying portfolio and are simply unsecured debt obligations, and the institution backing the product doesn't have to be invested in any assets tied to the VIX index, though it may.

That also means ETN investors are subject to the issuer's credit risk. If the issuer declares bankruptcy, investors in an ETN could lose their entire investment. ETNs also have a set maturity date, but some can be called at any time, which would in effect force you to cash out of your investment, whether you wanted to or not.

And the risks of investing in an ETN extend even further. For more, be sure to read FINRA's Investor Alert “Exchange-Traded Notes—Avoid Unpleasant Surprises.”

In the end, volatility can seem like an interesting new asset class, but it is important to understand that not all exchange-traded products carry the same degree of risk. It's important that you understand these risks—and fully understand any product—before you invest.

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