How Volatility ETFs Have Made Billions of Dollars Disappear

Markets Motley Fool

The universe of exchange-traded funds has grown dramatically over the years, and there are many ETFs that can help you reach vital financial goals for yourself and your family. Yet along the way, there've been some funds that have been consistent losers for investors.

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Volatility ETFs have been among the biggest destroyers of wealth throughout their histories. A nearly decade-long bull market certainly hasn't done this asset class any favors, but a lot of the decline has resulted from a fundamental misunderstanding among some investors as to the true purpose of these investment vehicles.

Volatility ETF

Assets Under Management

Expense Ratio

5-Year Total Return

iPath S&P 500 VIX Short-Term (NYSEMKT: VXX)

$824 million

0.89%

(98.5%)

VelocityShares Daily 2x VIX ST ETN (NASDAQ: TVIX)

$188 million

1.65%

(99.996%)

iPath S&P 500 VIX Medium-Term (NYSEMKT: VXZ)

$38 million

0.89%

(84%)

What volatility ETFs were supposed to do

Initially, the purpose of volatility ETFs was fairly easy to understand. By seeking to track a popular measure of stock market volatility, the S&P Volatility Index (VOLATILITYINDICES: ^VIX), these ETFs aimed to allow investors to profit directly when markets became more turbulent. When these products first became popular in the late 2000s, the memory of the financial crisis made many investors want the sort of protection that these ETFs sought to provide -- or the profits that speculating in these high-risk, high-return assets could pay under the best conditions.

The big problem with volatility ETFs is that their structure makes it difficult to use them as long-term investment plays. For leveraged investments like the VelocityShares fund, the daily compounding of returns exacerbates downward trends over time. However, even the nonleveraged options among volatility ETFs weren't free of risk, because the conditions in the futures markets that they track and the methodology that the funds follow tend to erode the value of the fund's assets over time. That combination explains how even though the S&P Volatility Index itself has fallen substantially, the losses among these volatility-based investments have almost completely wiped out anyone who actually held onto shares in an uninterrupted manner over the years.

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Paying for risk management

Losses have taught those who owned shares of these funds a valuable lesson, but even investors who never touched volatility ETFs can learn a lot from them. As with any other risk management tool, volatility ETFs come with an inherent cost. Although they do a good job over short periods of time of hedging against dramatically increases in volatility, they can't do so over the long run.

Perhaps more importantly, the performance of volatility ETFs shows how much of a losing bet it has been to think that the U.S. stock market will stop producing the solid performance it has delivered for decades. It's true that the returns of the 2010s are extremely strong, and the length and consistency of stock market gains has been nearly unprecedented. But for most investors, the smarter way to control risk is to be smart about allocating money across different asset classes, ensuring that even an ill-timed bear market won't leave you in a difficult financial situation.

Embrace volatility

In the end, the ups and downs of the stock market can be the greatest tool that ordinary investors have. By occasionally bidding prices of good companies down in an unreasonable manner, the market allows smart investors to jump on opportunities when they arise. By sometimes sending share prices into the stratosphere, opportunistic investors can sell at best levels, finding other overlooked alternatives that have better prospects for the future.

Taking advantage of volatility to make rational investing decisions based on value and the quality of a business' future opportunities is a smart strategy. Trying to profit directly from volatility, on the other hand, has been a costly attempt for many traders over the years, and that losing strategy is one that long-term investors should avoid.

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Dan Caplinger has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.