A volatility exchange-traded fund (ETF) allows traders to bet on an increase in stock market volatility. It can be a very profitable bet if the market suddenly becomes more volatile, for example if it crashes, but the fund’s price continues to erode due to the way the fund is structured.
Here are some of the best volatility ETFs and ETNs, with data as of April 8, 2024.
What is a volatility ETF?
A volatility ETF gives traders the opportunity to bet on the volatility of the stock market. Unlike a typical ETF, which owns shares or options of real companies, a volatility ETF uses complex financial instruments called derivatives (such as futures) to create a fund that increases in value when the market gets shaky. When the market becomes more volatile, the fund can often rise quickly.
Volatility is often measured using the CBOE Volatility Index, better known as the VIX. It’s called the “fear gauge” because the index spikes when investors get nervous. Historically, the index has moved inversely to the Standard & Poor’s 500 Index. So a volatility ETF can be useful as a short-term hedge against a portfolio or as a one-sided bet on the direction of the market.
Like many other types of leveraged ETFs, volatility ETFs are intended to be owned for a very short period of time, often just for a day or two. Because they use derivatives, whose value tends to decline over time, volatility ETFs often swim against the fast-moving current. Because of this structure, volatility ETFs often perform very poorly over time as value leaks out of the fund.
Volatility funds can also technically be exchange-traded notes (ETNs), which have a slightly different structure than ETFs but can still track market volatility.
Best volatility funds
iPath Series B S&P 500 VIX Short-Term Futures ETN (VXX)
This ETN provides exposure to the S&P 500 VIX Short-Term Futures Index Total Return. Because it is an ETN, holders have no principal protection and own unsecured debt from the company sponsoring the notes, Barclays Bank.
- YTD return: -4.7 percent
- 5-year return (annualized): -48.8 percent
- Cost ratio: 0.89 percent
ProShares VIX Short-Term Futures ETF (VIXY)
This fund tracks the S&P 500 VIX Short-Term Futures Index, which tracks a portfolio of futures contracts with a one-month weighted average to expiration.
- YTD return: -5.2 percent
- Returns over 5 years (annualized): -49.1 percent
- Cost ratio: 0.95 percent
iPath Series B S&P 500 VIX Medium Term Futures ETN (VXZ)
This ETN tracks the S&P 500 VIX Mid-Term Futures Index Total Return. Because it is structured as an ETN, holders have no principal protection and own unsecured debt from the issuer, Barclays Bank.
- YTD return: -0.6 percent
- Returns over 5 years (annualized): -3.9 percent
- Cost ratio: 0.89 percent
ProShares VIX Mid-Term Futures ETF (VIXM)
This ETF tracks the S&P 500 VIX Mid-Term Futures Index, which tracks a collection of futures contracts with a weighted average expiration of five months.
- YTD return: -0.6 percent
- 5-year return (annualized): -4.6 percent
- Cost ratio: 0.94 percent
ProShares Short VIX Short Term Futures ETF (SVXY)
This ETF attempts to provide daily results that are half the inverse of the daily performance of the S&P 500 VIX Short-Term Futures Index. In other words, if this index were to rise 1 percent in one day, the fund would aim to fall 0.5 percent. If the index falls 1 percent, this fund aims to rise 0.5 percent.
- YTD return: –49.0 percent
- 5-year return (annualized): -0.87 percent
- Cost ratio: 0.95 percent
The pros and cons of volatility ETFs
Benefits of Volatility ETFs
- Easily accessible volatility exposure: When the market becomes turbulent, traders can flee to volatility ETFs to take advantage of the increasing uncertainty in the markets. So this type of fund offers an easy way to quickly access that exposure.
- Hedge on a portfolio: A volatility ETF can provide the ability to hedge a portfolio over a short period of time, offering an asset that rises while most others fall.
- The price can rise quickly: When the market suddenly becomes volatile, the price of some volatility ETFs can increase by hundreds of percent in just a few days. So if they place a trade on time, traders can quickly earn their stake many times over.
Disadvantages of Volatility ETFs
- Intended to be held for very short periods of time: Volatility funds are actually meant to be held for only a short period of time, which gives them exposure to the short-term movements of volatility.
- Value tends to decay over time: Due to the use of derivatives in the structure, the price of volatility funds tends to decline naturally over time.
- Unattractive returns in the long term: Buying and holding a volatility fund is unattractive because value seeps out of the funds over time through futures contracts.
What to look for with an ETF
When investing in ETFs, it’s helpful to look at some aspects of each ETF so that you actually buy what you intended to buy. Here are three important things to pay attention to:
- The targeted exposure: Volatility ETFs offer different exposures to the market, in terms of time frame (short and medium term), whether they perform inversely to what they track and whether they use a leveraged approach to magnify profits.
- The investment track record: You also want to know the track record of the ETF. The track record can give you an idea of what to expect from the ETF. But volatility ETFs are designed to perform well only over short periods of time, so in many cases the long-term returns look terrible.
- The expense ratio: Pay attention to the expense ratio, which tells you how much it costs annually to own the fund, as a percentage of your total investment in it.
How to Invest in Volatility ETFs
A volatility ETF can make it easier to profit if the stock market drops suddenly, or can even help you quickly hedge a position over a short period of time. But some funds benefit more when volatility increases, while short volatility funds perform well when the market remains calm and take advantage of the passage of time to make profits. So it is essential to know what exposure you want.
The ETFs mentioned above offer traders a way to gain exposure to volatility, but how they invest is up to them. Traders can aim for the moon with short-term volatility funds or take a more modest approach with medium-term funds, or even take advantage of calm markets with short-term funds.
Traders will also want to understand why they use volatility funds and when they are useful. Volatility ETFs can be useful in the short term, but their structure causes the typical fund to decline in value over time. So they can be great as a short-term hedge when the market is suddenly in danger, but traders looking for a longer-term hedge will look elsewhere.
You can buy volatility ETFs from one of the best stock trading brokers.
In short
Traders who want to take a short-term bet on the direction of the market may decide to use a volatility ETF to express that view. But volatility funds have significant drawbacks and their value tends to decline over time, even if it sometimes spikes as market volatility increases.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making any investment decision. In addition, investors are advised that the past performance of investment products does not guarantee future price increases.
