How to Invest in VIX ETFs

You can’t turn on the business news these days without hearing about the Volatility Index, or VIX.

When investors are anxiously buying and selling, causing stock market prices to reach greater highs and lows, the VIX tends to rise. Whereas when markets trade within a narrow range, the VIX remains lower.

If you’re wondering whether there is a way to profit from the trends of the VIX, it’s important to understand the pros and cons of VIX exchange-traded funds, and take a glimpse at strategies to smooth out the volatility of an all-equity portfolio.

[Read: Does Market Volatility Mean It’s Time to Rebalance Your Portfolio?]

To find out whether these types of investments make sense for you, here are some points to keep in mind:

— What is the VIX?

— How to invest in VIX ETFs.

— The risks of investing in VIX ETFs.

— What the experts say.

What Is the VIX?

Created by the Chicago Board Options Exchange, the Volatility Index is a real-time market index that represents the expectation of 30-day forward-looking volatility of the S&P 500.

The calculation of the VIX is based upon the prices of S&P 500 futures options.

An option is a financial derivative product that gives buyers the right, but not the obligation, to buy or sell the underlying asset at an agreed-upon price before a predetermined date. Options can be used for hedging, income or speculation.

How to Invest in VIX ETFs

Like all indexes, you can’t invest directly in the index.

But unlike the SPDR S&P 500 ETF Trust ( SPY) or the Invesco QQQ Trust ( QQQ), which tracks the returns of the Nasdaq-100, VIX ETFs track VIX futures indexes. “Because you can’t invest directly in the VIX, the products available for volatility exposure are only approximations,” says Mark Phillips, CEO at Harvested Financial in Chicago.

In fact, since VIX ETFs track futures indexes and not the actual VIX performance, investment returns may deviate from those of the VIX.

The following VIX ETFs are suitable for speculative investors who understand the risks.

For short-term traders: ProShares VIX Short-Term Futures ETF (VIXY). This short-term futures ETF attempts to track the S&P 500 VIX Short-Term Futures Index. The futures contracts owned within the fund expire within one month.

This index measures the returns of a portfolio of monthly VIX future contracts. As a short-term trading tool, it’s appropriate for sophisticated investors. VIXY can reduce U.S. equity portfolio risk, since changes in the VIX short-term future index typically display a negative correlation to S&P 500 returns.

If an investor believes that the S&P 500 is due for a decline, this fund may be expected to rise in value. A speculator who believes markets are due for a fall might also consider a short or inverse S&P 500 fund like the Direxion Daily S&P 500 Bear 1X ETF ( SPDN), which is created to provide 100% inverse exposure to the returns of the S&P 500.

VIXY comes with an expense ratio of 0.85%. Its year-to-date return is 119%.

For moderate traders: ProShares VIX Mid-Term Futures ETF (VIXM). This VIX ETF provides investors with exposure to the S&P 500 VIX Mid-Term Futures Index. VIXM tracks the returns of a portfolio of monthly VIX future contracts with an average expiration maturity of five months.

VIXM might be appropriate for investors seeking to profit from increases in anticipated volatility in the S&P 500 during an intermediate period. Since the fund has been negatively correlated with the returns of the S&P 500, it may provide additional portfolio diversification.

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Like all VIX ETFs, this fund is recommended as a shorter-term trading vehicle. These aren’t investments to buy and hold.

Since the fund tracks the VIX futures market and not the actual CBOE Volatility Index, it is expected to perform differently from the actual VIX.

VIXM has an expense ratio of 0.85%. Its YTD return is 90%.

For speculators: iPath Series B S&P 500 VIX Short-Term Futures ETN (VXX). Another VIX futures fund, this one tracks the returns of VIX futures in the first and second month. It reflects the market participants’ views of the future direction of the VIX for the specified time periods.

Each of these VIX ETFs differs slightly in the length of futures contracts that they track. This is a nuance, applicable to traders seeking to profit from various time periods of expected volatility of the VIX futures markets.

The fund’s expense ratio is 0.89%. Its YTD return is 120%.

The Risks of Investing in VIX ETFs

While the potential for triple-digit gains are an attractive feature of these funds, there are a few risks associated with investing in VIX ETFs.

Again, VIX ETF investing isn’t for buy-and-hold or beginning investors.

These funds are designed for active traders and speculators seeking to outperform the markets and counteract declines in the S&P 500.

Contango is one risk of investing in VIX futures, or any futures contract for that matter. Contango occurs when the futures price of a commodity or asset is higher than its current price. Thus you are buying the contracts at a higher price than the current value.

For example, if a one-month VIX futures contract is trading at $16 and the current hypothetical VIX price is $15, the market is in contango. When you buy the futures contract during this situation, you’re paying a premium, similar to buying high and selling low.

In fact, according to Michael Iachini , vice president, head of manager research at Charles Schwab Investment Advisory, the value of VIX futures contracts between 2016 and 2019 has lagged that of the VIX index.

This doesn’t mean that an investor should steer clear of investing in VIX futures. Instead, they should be aware of the risks as well as the benefits.

What the Experts Say

There are a variety of tactics to profit during volatile market movements.

Most involve making a prediction on the future direction of stock prices. Since no one has a crystal ball, investing in VIX ETFs is considered speculative and appropriate for investors who are aware of both the potential gains and losses.

Before investing in VIX ETFs, it might help to see what the experts are saying. “The cost of maintaining VIX-like exposure is high and not intended for long-term investing,” Phillips says.

[Read: How Millionaires Invest During a Bear Market.]

Rob Isbitts, chief investment officer at Sungarden Investment Research, isn’t a fan of VIX ETFs either. He maintains that investors can short certain market sectors that they believe are due for a fall.

Jeff Landle, CIO of Little Harbor Advisors in New York City, offers another strategy to provide upside participation in the market while curbing losses. Specifically, Landle uses a proprietary Smart Indexing strategy that incorporates S&P 500 indexing and covered calls for risk management — which will obviously go beyond an average investor’s scope.

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