Advisers should think twice before adding volatility ETFs to client portfolios

You might be adding volatility, not reducing it

Aug 17, 2016 @ 12:08 pm

By John Waggoner

If your clients are worried about stock market volatility, your first question might be to ask them why. And if you're considering using a volatility exchange-traded fund to combat volatility, you might ask yourself why as well.

According to the third-quarter Eaton Vance Advisor Top-of-Mind survey, volatility is the chief concern among financial advisers, with 56% of those surveyed saying that their worries about volatility have increased over the past 12 months. And several fund companies, including BlackRock, State Street Global Advisers and TIAA, have all warned about volatility in the coming months.

At the same time, the stock market volatility has been about average. The past 12 months, the Standard and Poor's 500 stock index has had 1% intraday moves up or down 77 times. That's the average for the past 12 years. (Volatility cuts both ways: the S&P 500 has jumped up 41 days and fallen down 36 days. That's about average for down days and above average for up days.)

The CBOE volatility index, called the VIX index, is another measure of volatility. Called the fear index, it measures what the options market expects volatility to be in the next 30 days. The VIX closed at 13.26 on Tuesday, up 4.91%, but still down from its high of near 40 in September 2015.

The VIX is normally quiet in summer, when investors are more concerned with their vacation plans than their portfolios. But September and October are traditionally the most volatile months of the year; the market is historically expensive, and there's that whole presidential election thing coming up in November.

Wouldn't it make sense, then, to add a VIX ETF to portfolios of investors who are currently fretful? After all, the alternatives are somewhat fraught. You could raise cash, for example, which would dampen volatility but also reduce returns if the market rallies. Or you could add bonds, but you'd be doing so at a time when interest rates are near historic lows.

Most of the VIX ETFs, however, have the same problems as most commodity funds. Most commodity funds don't invest directly in cattle or hogs, but in futures contracts, rolling them over into the next contract as a settlement date approaches. If the next-highest contract sells for more than the current one, the fund will have to pay up – and that creates a drag on performance. (If you want to impress the easily impressed, this is called “contango.”)

Contango typically causes a drag on returns, as well as substantial tracking deviation from the index itself. The largest VIX exchange-traded product, iPath S&P 500 VIX ST Futures ETN (VXX), is actually an exchange-traded note, so contango isn't as much a worry. It is, however, an unsecured fixed-income obligation, which carries credit risk.

Another problem: The VIX ETF can be a source of volatility on its own. “At one time I thought using the VIX ETF would allow our investment team to reduce volatility,” said Mark S. Germain, a financial planner in Hackensack, N.J., in an e-mail. “However, we tested it on our own accounts and found it was its own level of volatility generator. The ETF pricing and daily repricing would not allow us to allocate across 700 accounts effectively.”

This is a good point: VXX, which has fallen 44.7% this year, has a three-year standard deviation of 63.92. In contrast, the SPDR S&P ETF (SPY), has a three-year standard deviation of 11.08. While volatility cuts both ways, few investors would be happy with adding a vastly more volatile investment that has fallen almost by half.

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