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Exchange-Traded Funds (ETFs)

Volatility Investing—Not for the Faint of Heart

People riding a rollercoaster ©iStockPhoto/bukharova

The investor on the other end of the line was distraught. He put virtually all of his family's assets into an exchange-traded product (ETP) that tracked the inverse of the performance of futures on the Cboe Volatility Index or VIX.

When it comes to volatility-linked
products, understand the investment,
and only invest what you can afford to lose.

The investment, which he purchased on margin, crashed. He got a margin call from his brokerage firm that confirmed his worst nightmare: his money was gone—and he might have to mortgage his house to pay off the margin debt. Today the product he bought no longer trades.

As we mentioned in an earlier article, investors could risk major losses if they trade volatility-linked ETPs without fully understanding how they work. These products are generally not designed to be used as buy-and-hold investments—and while they can generate eye-popping gains (a number of inverse volatility-linked ETPs had returned over 180 percent in 2017), they can also quickly lose some or all of their value in a very short time.

Volatility investing is not for the faint of heart. When it comes to volatility-linked investment products, make sure you fully understand the investment and only invest what you can afford to lose.

VIX Basics

During the market turmoil experienced in late 2008, financial news media began routinely reporting the level of the VIX, broadening awareness of "volatility" as an asset among the investing public.

The VIX is not based on actual price fluctuations experienced on a given day (or over some other timeframe) but instead reflects an expectation of volatility over the next 30 days as implied by options prices.

The VIX historically tends to be elevated in periods of market distress—often moving sharply higher when stock indices decline significantly—and lower under more normal market conditions. As such, the VIX is generally considered to be negatively correlated with the broader stock market—an attractive feature for those desiring to hedge market performance.

Uniquely, but importantly, the volatility asset as captured by the VIX is unlike more traditional assets such as equities in that it tends to be "mean-reverting:" its level returns back to an average or "steady-state" after increases or declines—and its level has historically been constrained within a limited band.

Crucially, the VIX itself is not investible. Investors generally obtain exposure to volatility using VIX futures or other derivatives. For example, volatility-linked ETPs tend to track VIX futures. 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. The price "sensitivity" of VIX futures 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.

A variety of volatility-linked ETPs exist. The most basic offer long exposure to a targeted VIX futures maturity. They tend to offer tactical hedges against, or speculative positions on, movements in the VIX. There are also leveraged and inverse versions of these, as well as ETPs with more sophisticated strategies.

Whether basic or sophisticated, virtually all volatility-linked ETPs are complex, and their strategies and objectives can vary from product to product. If you are seriously considering investing, do yourself a favor and read the prospectus—the whole thing—and read the information about risks twice.

Volatility Products and Margin Risk

As investors found recently, one significant risk of volatility-linked ETPs is swift and significant short-term losses. These in turn may trigger a margin call.

When you buy on margin, you enter into a loan agreement with your securities firm. In general, under Federal Reserve Board Regulation T, firms can lend a customer up to 50 percent of the total purchase price of a marginable investment for new, or initial, purchases. In the event of a margin call, the customer will be required to deposit the other 50 percent of the purchase price.

If the price of a security falls quickly—as can be the case with volatility-linked ETPs—a margin call can come with equal speed, catching a customer off guard. A customer's failure to satisfy the call may cause the firm to liquidate a portion (or all) of the customer's account.

If you buy securities on margin, keep the following in mind:

  • You can lose more funds than you deposit in the margin account. A decline in the value of securities you purchased on margin may require you to provide additional funds to the firm that has made the loan to avoid the forced sale of those securities or other securities in your account. This is known as a margin call.
  • The firm can force the sale of securities in your account. If the equity in your account falls below the maintenance margin requirements under Federal Reserve Board Regulation T—or the firm's higher "house" requirements—the firm can sell the securities in your account to cover the margin deficiency. You will also be responsible for any shortfall in the account after such a sale.
  • The firm can sell your securities without contacting you. Some investors mistakenly believe that a firm must contact them before liquidating securities to satisfy a margin call. This is not the case.
  • A firm does not have to grant an extension. While an extension of time to meet initial margin requirements may be available to customers under certain conditions, a customer does not have a right to the extension.

Volatility-linked products let you experience volatility first-hand in your portfolio—something that is certainly not for everyone. Before you invest, do your homework and consider whether what you know or don't supports your investment in a product or strategy, research the risks involved, and be prepared for what could be a heart-pumping ride, including that you can afford any risk of loss of all or part of your investment.