Meet the VXX, an Investment That Can Sink You

The stock market doesn't advance in a straight line, and some people try to profit from the volatility.

When it comes to getting some insight into expected market volatility, many investors look at the "VIX" -- theChicago Board Options Exchange Volatility Index, which measures short-term expectations about the market's moves. And those who want to profit from bets on volatility in the market can invest in the Barclays Bank PLC iPath S&P 500 VIX Short-Term Futures ETN , which is focused on the short-term movement of the VIX index.

Think twice before buying into the VXX ETN, though, as it can be a terrible investment. Let's go over why.

The basicsBefore going any further, note that the VXX is not an exchange-traded fund -- a stock-like fund that often tracks a stock index. Rather, it's an exchange-traded note -- a debt instrument. It's only as safe as its issuer, and taxes are dueon any interest or coupon payments it makes to shareholders. Whereas ETFs will generally have annual, taxable distributions of dividends and capital gains, ETNs will generally not realizea capital gain or loss until the shareholder sells the security. This allows investors to defer taxation and enjoy lower long-term rates.

The VXX ETN is based on the VIX index, which aims to gauge stock market investors' anxiety by aggregating current prices for put and call options for the S&P 500 Index, running them through some calculations, and producing an educated guess about how much the index is likely to move over the coming 30 days.

What's so bad about it?Investing in the VXX can make you money over a short time frame if there's some market-moving event such as a major rate adjustment by the Federal Reserve or a government shutdown. But you have to be right about the near-term direction of the market, which is hard to do consistently.

If you buy into the VXX and then forget about it, you can end up with a nasty surprise. Over the past year, it has lost investors close to 50%. It's not meant to be a long-term investment. Because it's based on short-term VIX futures, it has to keep adding the latest futures, and often each one is a bit pricier than the last. This means there tends to be an ongoing cost and therefore a negative return. The phenomenon at work here is called "contango." On top of contango losses, the ETN also charges fees, as do other ETNs and ETFs.

Vance Harwood of sixfigureinvesting.com has said of the VXX ETN: "From a public relations standpoint VXX is a disaster. It's frequently vilified by industry analysts and resides on multiple Worst ETF Everlists."

What to do?Offering advice regarding the VXX ETN is rather simple: Consider simply steering clear. Many investors have made great fortunes without ever going near it. The ETN is based on short-term guesses about an index that's based on short-term guesses. Instead, you should put your hard-earned money in solid investments -- like shares of healthy, growing companies that are poised to appreciate over time, or bonds that you understand and that don't have a structural tendency to lose value over time.

The article Meet the VXX, an Investment That Can Sink You originally appeared on Fool.com.

Longtime Fool specialistSelena Maranjian, whom you can follow on Twitter,has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.