An increasingly popular investment product that tracks the volatility of financial markets is “virtually guaranteed to lose money” over the long term, says a Vanderbilt University finance professor.
The number of Exchange Traded Products (ETPs) — which are bought and sold like shares of stock and are open to nearly all investors — tied to the Chicago Board Options Exchange’s Market Volatility Index (VIX) has increased significantly since 2009. Today there are more than 30 VIX-related ETPs with a total market value of approximately $4 billion.
Many sophisticated investors use VIX futures and options to hedge against deep and sudden downward drafts in the market. But in a forthcoming paper for the Journal of Portfolio Management, Robert E. Whaley, Valere Blair Potter Professor of Finance at Vanderbilt’s Owen Graduate School of Management, said ETP products, aimed at retail investors, are likely causing more harm than good.
Whaley’s paper shows that because of the way VIX ETPs are structured, they fall into a “contango trap” in which prices systematically fall over time. This happens because the prices of the VIX futures used in the ETPs exceed the expected future levels of the VIX.
Nonetheless, investors continue to buy ETPs, speculating that VIX will spike or as a hedge against market turmoil. For investors who plan to hold VIX ETPs over the long term Whaley offers two suggestions:
- Buy products focused on mid-term, not short-term, VIX futures.
- Consider only VIX ETPs that provide interest accrual.
Whaley created the VIX for the Chicago Board Options Exchange in 1993, and trading in futures on the VIX began on the CBOE Futures Exchange in 2004.