The VXX: It's Not Quite What It Seems

Just like the Stelvio Pass Road in the Alps, the stock market doesn't move in a straight line. Be careful if you try to profit from the volatility, though. Image source: Pixabay

You may know that the Barclays Bank PLC iPath S&P 500 VIX Short-Term Futures ETN is a way to bet with your dollars on the direction of the market. Should you take that bet, though? Probably not, as the VXX is not quite what it seems, in several ways.

In a nutshellThe VXX is based on the "VIX" -- theChicago Board Options Exchange Volatility Index that reflects investors' expectations about the short-term direction of the S&P 500 by assessing current prices for put and call options tied to the widely followed index, producing an educated guess about how much the index is likely to move over the next 30 days therefrom. Thus, those who want to profit from bets on volatility in the market might invest in the VXX. It's not a good idea for most of us to do so, though, for a variety of reasons.

It's not an ETFMany people assume the VXX is an ETF, an exchange-traded fund, but it's not. ETFs are stock-like instruments, offering pooled ownership stakes in real securities. They're typically based on indexes such as the S&P 500. The VXX, though, is an exchange-traded note -- a debt instrument. Therefore, it's only as safe as its issuer, and taxes are dueon any interest or coupon payments it makes to shareholders.

A plus, though, is that while ETFs generally make annual taxable distributions of dividends and capital gains to shareholders, ETN investors generally don't realizea capital gain or loss until they sell the security, thus deferring taxation and allowing for lower long-term capital gains tax rates.

Image source:Lendingmemo.com.

It doesn't perfectly track the VIXIt might seem like the VXX is the perfect way to profit from the rise or fall of the VIX, but they're different beasts. An ETF tracking a stock index can simply own the same stocks as the index, in the same proportions. It's not so easy for the VXX, because the VIX isn't a straightforward collection of securities. Instead, it's based on algorithms that are based on options on the S&P 500.

At thestreet.com, Russell Rhoads of theChicago Board Options Exchange notedthat the VXX and the VIX have been in sync between 77% and 89% of the time in the period that they have both existed. The VXX comes relatively close to precisely tracking the VIX, but it's far from perfect.

It's often more likely to drop in value than to riseAnother tricky detail is that the VXX ETN is structured in such a way that it is often in "contango," a condition where the instrument faces higher prices from month to month, decreasing its value. Since the VXX is based on short-term VIX futures, it has to keep adding the latest futures, and each one is frequently a bit pricier than the last. Thus, there's often an ongoing cost and, therefore, a negative return.

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%; since inception, it's down approximately 99%. Clearly, then, you shouldn't view this as a long-term investment.

The bottom line is that most of us have no business going near the VXX, unless we've studied it closely and fully understand what it does and doesn't do. If you don't know what you're doing, you can end up surprisingly poorer. Fortunately, avoiding the VXX isn't likely to hurt you at all. If you're aiming to amass a lot of wealth, you can do so the old-fashioned way, by investing in healthy and growing companies and hanging on for the long haul. Or be less involved and stick with low-cost, broad-market index funds, such as the SPDR S&P 500 ETF, Vanguard Total Stock Market ETF, and Vanguard Total World Stock ETF.Respectively, they distribute your assets across 80% of the U.S. market, the entire U.S. market, or just about all of the world's stock market.

The article The VXX: It's Not Quite What It Seems 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.