The House Always Wins With Volatility ETFs

new etfsDavid Fabian:  Pick your favorite casino vice – craps, roulette, black jack – each of these games involves a little bit of skill and luck to leave the table with more money than you started with.  Nevertheless, every gambler knows that overstaying your welcome will lead to tragic results.

Put simply, over a long enough time frame, the house always wins.

This same philosophy can also be applied to funds that track volatility futures.  These indexes can experience sharp rallies that quicken the pulse and dilate your pupils, but they also have led to consistent wealth destruction over the last seven years.

Charlie Bilello, Director of Research at Pension Partners, recently posted the following data set for the iPath S&P 500 VIX Short Term Futures ETN (NYSEARCA:VXX).  This exchange-traded note is the largest and most well-known fund that tracks an index of long volatility futures.

The CBOE VIX Volatility Index (VIX) was created as a way to measure fear and greed in the marketplace through the calculation of options activity.  As a pure index, this works relatively smoothly to gauge the overall positioning of investors as they seek to add or reduce risk through their exposure to stocks via the options market.  Volatility tends to expand when stocks drop and contract when they rally.

$VIX_$SPX

However, that same philosophy runs into a variety of problems when applied to a tradeable investment vehicle such as VXX.  Because it invests in futures contracts, VXX is subject to a myriad of structural issues that include time decay, contango, contract roll, and fees.

VXX

You almost need to be a math genius to truly understand the underlying risks and daily price fluctuations that drive this fund.  That level of complexity is far outside my skillset and works against my personal philosophy of keeping portfolio management simple.

The crazy thing is that despite all of these issues, VXX is beloved by traders with a gamblers zealotry for striking it big.  Yahoo Finance lists average three-month dailytrading volume at 66 million shares.  According to the fund company website, VXX currently has $1.54 billion in total assets.  That’s a lot of conviction in a product that has been a consistent headache for the majority of investors that have tried using it.

Can you make money in VXX?  Absolutely. You have to get in, get out, and move on with a little bit of skill and a whole lot of luck.

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