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The VIX volatility index is a mathematical calculation, not a stock, so it cannot be invested in directly. Rather, traders can invest in the VIX through futures, options, or ETFs. Even the best VIX ETFs aren’t a good idea for long-term investors, due to their poor correlation with the VIX and its inherent downward bias.
What is the VIX?
In a nutshell, the VIX is the ticker symbol for the CBOE (Chicago Board Options Exchange) Volatility Index, which is a measurement of the implied volatility of S&P 500 index options. Essentially, a higher VIX means that traders expect a more volatile market over the next 30 days. For this reason, the VIX is commonly referred to as the “fear gauge” or “fear index” of the market.
VIX futures have been trading on the CBOE since 2004, and take into account the current market prices for all out-of-the-money call and put options for the front month and second month expirations.
While the actual calculation of the VIX is quite complex, the index is quoted in percentage points and represents the expected range of movement of the S&P 500 over the next year, with a 68% confidence interval (one “standard deviation” in statistics terms). For example, if the VIX is 20, we can interpret this as “traders are 68% confident that the S&P 500 will remain within 20% of its present level over the next 30 days.”
Without going into the mathematics too deeply, in order to convert the VIX to expected monthly or weekly volatility, you can divide by the square root of either 12 (3.46) or 52 (7.21). So, a VIX of 20 would imply a monthly range of +/- 5.8%.
VIX ETFs – Not a perfect correlation
There are a few ways investors can trade the VIX. VIX futures contracts and options have been available for over a decade, and are the derivative instruments directly tied to the VIX. However, since the VIX is not a stock, but a mathematical calculation, there’s no way to invest in it directly.
One alternative is to buy a VIX ETF, such as the iPath S&P 500 VIX Short-Term Futures ETN (VXX), which is the most popular volatility-based ETF. This ETF, and other VIX ETFs, invest in VIX futures contracts. This doesn’t produce a perfect correlation to the VIX. In fact, on a 25% spike in the VIX on August 20, 2015, the iPath ETF only gained 8%.
And, because of the structure of futures-based ETFs, the funds must buy more expensive longer-dated contracts while selling cheaper short-dated ones, effectively buying high and selling low. Over time, this creates a downward pressure on the ETF’s price. To illustrate this, consider that while the VIX has dropped by 20% since the beginning of 2013, the iPath ETF has plunged by nearly 92%.
In short, a VIX ETF is not a good long-term investment. It’s also important to point out that ETFs that effectively short the VIX have the same downward bias over time. To be perfectly clear, VIX ETFs are virtually guaranteed to lose money over the long term.
Why would anyone buy a VIX ETF?
Having said all of that, there are some legitimate uses for VIX ETFs. For example, an investor may buy a VIX ETF to hedge against short-term volatility in the market. The VIX tends to spike when the market drops rapidly, making a volatility-tracking ETF a protective bet against a market crash. The Brexit vote is a good recent example – an investor could have bought shares of the iPath ETF the day before the Brexit vote to protect against a possible market crash. In this case, the S&P 500 lost 3.6% on the following trading day, while the ETF would have gained 24% on the spike in the volatility, thereby helping to offset any losses.
However, this type of strategy is a variation of market timing, and is generally not a good idea for investors. In fact, any investment with a downward bias – VIX ETFs, leveraged ETFs, and any other futures-based ETF product – is generally not a good idea for investors with a long-term mentality.
The bottom line on VIX ETFs
While instruments like VIX ETFs do indeed serve a purpose in the market, they are best left for professionals and short-term traders. Volatility spikes can certainly cause your stocks to drop in the short-term, but as long as you have a well-diversified portfolio of rock-solid companies, simply stay the course and you’ll be fine in the long run.
