Betting on the 'Fear Index'

In response to the market’s recent swings, a growing number of investors—from hedge fund managers to retail investors—are making bets on what looks like the only sure thing: market volatility itself. They are making these bets via 28 new exchange-traded funds or notes that track the Chicago Board Options Exchange Market Volatility Index, more commonly known as the VIX. The oldest was launched in 2009. From January to August, assets in the group grew 32% to $2.8 billion.

market index

The short-term returns for some of these products look pretty fantastic. The biggest of the bunch, the iPath S&P VIX Short-Term Futures ETN, gained 47% in the month ended Sept. 9, according to fund-tracker Morningstar, Inc. The most straightforward VIX-linked investments—those that don’t offer amplified or inverse returns—gained 38% on average in the same period.

Often called “the fear index,” the VIX measures how rocky investors expect the market to be, based on the prices of options contracts. (The more stock prices are expected to swing, in either direction, the more expensive options contracts become.)

But the dazzling performance may blind some investors to the nuances of these investments. The VIX has no intrinsic value. The futures contracts it holds only rise in value when investors think fluctuations will be more extreme tomorrow than they are today. Investors’ fears and speculation are themselves a volatile asset, notes Timothy Strauts, an ETF analyst with Morningstar, and the VIX “just oscillates from fear to calm and back.”

Because of how the funds are designed, it is also difficult to make long-term gains betting on fears of volatility. Consider that the VIX was recently at 43, up from 27 a year ago. Yet over the same period, an investor who bought and held the iPath ETN would have lost 55%. That is because if volatility rises or even stays flat, the underlying options contracts get more expensive. To keep up, the ETFs are constantly selling cheap contracts in favor of more expensive ones, and investors who hold the funds for more than a few days notch those losses.

These products are designed for short-term traders, says Tim Edwards, a vice president at Barclays Capital. If an investor expected volatility to spike, say, after the Federal Reserve meets on Sept. 20, he would typically buy a VIX-linked fund a few days before, and hold it for less than a week. Essentially, making a profit through a VIX-linked product requires perfect market timing—a skill that history shows is in short supply.