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What Are Inverse Volatility ETFs?
Inverse volatility ETFs (IVETFs) is one of the most exciting financial market developments of the last decade. They are the first instrument listed on stock exchanges that allow investors to profit from falling volatility.
Volatility is not only a function of the stock market but of the options market which is used for hedging and speculation.
Volatility ETFs hold positions in the VIX volatility index, while inverse volatility ETFs hold short positions in the index. Before discussing inverse volatility ETFs, it’s important to understand implied volatility and exactly the what the VIX actually represents.
Volatility, as measured by the standard deviation of returns, is a measure of the historical volatility of an asset’s price.
However, in the options market a slightly different measure, implied volatility, is used to calculate option premiums. Implied volatility is one of the variables that go into an option pricing formula – along with the current price, the strike price, expected dividends and interest rates. An option’s price therefore implies a specific level of volatility that the market is expecting in the future.
The VIX Index
The VIX Index, which was created in 1993 is an index of the volatility of a basket of S&P500 options. These options are used to protect portfolios, and the VIX, therefore, indicates the level of fear in the market by showing the supply and demand in the options market.
It’s not possible to invest in the VIX itself and volatility ETFs, therefore, invest in futures on the VIX. Inverse vol ETFs hold short positions in the same futures contracts.
When do Inverse Volatility ETFs perform well?
IVETFs perform when volatility falls over short periods. But they also appreciate due to a phenomenon is known as contango.
Contango And Backwardation
In fact, most of their performance over the past seven years can be attributed to contango. Contango exists when buyers in a market consistently pay a premium above fair value. During periods when markets are rising or flat and when economic conditions are benign, VIX futures trade at a premium of up to 2%. That means holders of long VIX futures positions lose around 2% every time they roll positions from one month to the next.
That loss for holders of long positions is a profit for holders of short positions in VIX futures. That’s how IVETFs earn a premium every month.
Backwardation is the opposite of Contango– even if volatility falls, backwardation can lead to losses for IVETFs. You should only buy an IVETF if the term structure chart is rising. You can view that here.
Rising Curve Indicates Contango
If the curve is rising from left to right, it means buyers are paying a premium each time they roll their position from one month to the next. That means IVETFs are earning money every month. If the curve is falling, IVETFs will lose value every month.
If volatility spikes, IVETFs will lose value. When equity markets are rising, spikes in volatility will often be followed by a selloff in volatility. However, during bear markets, volatility can make a series of new 12 months highs in succession.
The most well-known inverse vol ETF, XIV, has been around since 2010. The period from 2009 to 2017 has been characterized by low and falling volatility. Still, in that time the XIV ETF has fallen over 25% in a single day, and it’s fallen more than 15% in one day on 11 separate occasions.
Inverse volatility ETFs should not be viewed as long-term investments, but as trading tools.
When to Enter a Trade
- Firstly, traders should only buy IVETFs when contango is present in the VIX futures market.
- Secondly, the ideal time to buy IVETFs is when volatility has spiked following an unusual event. The VIX level will usually be too high when markets panic, but fall when the news is properly digested.
When to Exit a Trade
- If the VIX futures market moves into backwardation there is no reason to hold an IVETF unless it’s likely that volatility will fall a lot.
- In case an IVETF is bought after a volatility spike, and volatility does not fall fairly quickly then positions should be exited – this may mean volatility could move even higher.
- If economic conditions point to rising volatility, positions should be exited, and the market should be avoided.
The Three Top Invest Volatility ETNs To Trade In 2018:
Note: Three of the following instruments are ETNs (exchange traded notes), while the first is an ETF. ETNs are more like a contract or bond, and less like an investment trust.
While ETF owners actually own the underlying instruments, ETN owners enter into a contract with the issuer. ETNs also have a maturity date when they expire and are replaced with a new fund.
Expense ratio 0.83% | Asset under management: $1.06 billion | Download Factsheet
Unlike most volatility products, SVXY is actually an ETF. That means it may be subject to tracking error, though in reality it has tracked the XIV ETN (see below) very closely.
Volatility ETFs have fees that range from 0.83% to 3.03%, so while this fund’s fee may seem high, it’s the lowest amongst the peer group. These fees should also be viewed in the context of the returns which have been around 100% per annum over the past five years.
Because SVXY is an ETF, it does require a K-1 tax form, which ETNs don’t. This is a small disadvantage for US taxpayers.
Expense ratio 1.35% | Asset under management: $1.2 billion | Download Factsheet
XIV is an exchange traded note, and was the first IVETF ever issued. It is very efficient at taking advantage of contango. XIV is one of the two top performing IVETFs, though it also has higher volatility than most of its peers.
2017 – VelocityShares Daily Inverse VIX Short-Term ETN (XIV)
The expense fee is 1.35%, which is high relative to most ETFs, but in the middle of the range when measured against other volatility ETFs.
Expense ratio 1.35% | Asset under management: $191 million | Download Factsheet
The ZIV ETN holds positions in slightly longer dates VIX futures. That means they experience lower volatility. Over the last five years, this fund has returned 235%, while XIV and SVXY have returned over 520%. However, this has been a period of unusually low volatility.
ZIV is a good option for those who are less experienced at trading volatility, those who want lower risk and those who would prefer to trade less frequently.
It’s also a good instrument to use alongside long equity ETFs to diversify the source of returns during bull markets. Adding a small allocation (5-10%) of this ETN will mean that returns will come from rising equity markets as well as from the contango premium.
The expense fee at 1.35% is high when one considers that the fund will usually have lower returns than its peers. For a small longer term holding the fee may be manageable. More active traders may however want to consider a smaller position in XIV, which will generate similar returns for a lower fee.
Other Inverse Volatility ETNs
Apart from the three funds mentioned above, there are four other inverse volatility ETFs. Neither of these are recommended now, but that may change in the future.
iPath Barclays ETNs (XXV maturing in and 2020 and IVOP maturing in 2021) are identical ETNs with different maturity dates. They have the lowest expense ratios in the segment, but also have very low liquidity and are therefore not recommended at this point.
VelocityShares VIX Short Volatility Hedged ETN (XIVH) is similar to the other Velocity Shares funds but has very low liquidity for the fee it charges.
REX Vol MAXX Inverse VIX Weekly Futures Strategy ETF (VMIN) is an actively managed inverse volatility ETF. Its performance has been good, but the track record at just over 12 months is not long enough, the fee is astronomical at 3.03%, and liquidity is very low – the fund has assets under management of only $16 m.