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The Big VIX Short

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If investors should have learned anything from the lead-up to the 2008 recession, it’s that something that seems too good to be true almost certainly is.

The recent downfall of two exchange-traded vehicles that bet against volatility has provided investors with a reminder of that lesson.

The two products that recently crashed to earth allowed investors to bet on the Chicago Board Options Exchange Volatility Index, more often referred to by the abbreviation VIX. The VIX, also known as the “fear index,” tracks the stock market’s expectation of volatility as implied by Standard & Poor’s 500 index options. It has been unusually low for a long time. But low volatility was never going to last forever, as some investors discovered abruptly when the market took a dramatic downturn last week.

The Wall Street Journal reported that the VelocityShares Daily Inverse VIX Short-Term ETN and the ProShares Short VIX Short-Term Futures ETF together represented more than $4 billion in investments when the VIX experienced a record spike of 115.6 percent. Both products were structured to make money for their investors as long as volatility stayed low. When the VIX spiked, the vehicles plummeted in value, both falling well over 75 percent. Credit Suisse has announced that it will liquidate the Velocity exchange-traded note on Feb. 21; the ProShares exchange-traded fund has resumed trading after a suspension, but lost a substantial portion of its value.

The Velocity product’s prospectus was blunt about the risks posed by a spike in volatility, stating that if futures jumped by more than 80 percent in a day, the fund could be entirely liquidated. ProShares included a similar prospectus warning. As Jared Dillian observed at Bloomberg, “If investors had read the prospectuses, there would not have been any surprises.” But, as with software terms of service, many people don’t read the fine print. And investors were easily lured by sky-high returns; the Velocity product gained 188 percent in 2017 and the ProShares fund, 180 percent.

Columnist Peter Coy put it even more bluntly: “Essentially, investors were picking up nickels in front of a steamroller.” While investors who sold their positions before last week made more than nickels, short exposure to the VIX was similar to selling insurance against volatility. As anyone who works for an insurance company knows, when premiums are underpriced and disaster hits, it can be the end of the line for the insurer.

To be clear, these two products were not the only ways to bet on volatility. Because the VIX generally rises when stocks decline, many investors originally saw betting on it as an attractive insurance policy, especially since exchange-traded products pegged to the VIX arrived in 2009, just after the housing market crash. But as markets calmed down, investors began to prefer betting against volatility in a variety of ways, including but not limited to buying shares of exchange-traded products like those offered by Velocity and ProShares.

However investors approached it, betting against volatility created the predictable but unfortunate consequence of magnifying stock losses rather than hedging against them. And based on some investors’ online laments, they may not have had a solid grasp of what this would mean when years of quiet VIX levels ended.

The moral of this story is not that investors should avoid taking risks. It’s that investors need to really understand what they are buying, especially when they invest in esoteric niche products. Funds tracking the VIX can be extremely risky, and it is important to understand this before jumping in headfirst. If a product is too complex for an investor to grasp, he or she would generally do best to steer clear and look for opportunities elsewhere.

At Palisades Hudson, we were familiar with funds taking bets against volatility and their outsize returns in recent years. But we never used them, because we didn’t believe there was a long-term economic case for making such an investment. As is the case with many other speculative investments, the returns on VIX investments can be lucrative if you time your purchases and sales perfectly. But unless you know that you will be buying and selling at the ideal times – which, unfortunately, is impossible – you run the perpetual risk of seeing your investment quickly wiped out.

These products did exactly what they were designed to do. While it is too late to say “buyer beware” to the investors who got burned this time around, it is a useful reminder to pay attention to where you’re putting your money.

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