Best volatility ETFs: Use these funds to profit when the market falls

James Royal, Ph.D. | (TNS) Bankrate.com

A volatility exchange-traded fund (ETF) lets traders bet on an increase in the stock market’s volatility. It can be a highly profitable wager if the market suddenly becomes more volatile — for example, if it crashes — but the fund’s price constantly erodes due to how the fund is structured.

Here are some of the best volatility ETFs and ETNs, with data as of August 2, 2024.

What is a volatility ETF?

A volatility ETF gives traders the ability to wager on the stock market’s volatility. Unlike a typical ETF, which owns stock or options of actual companies, a volatility ETF uses complex financial instruments called derivatives (such as futures) to create a fund that rises in value when the market gets rocky. If the market does become more volatile, the fund may soar, often quickly.

Volatility is often measured by the CBOE Volatility Index, commonly known as the VIX. It’s called “the fear gauge” since the index spikes when investors get nervous. The index historically moves inversely to the direction of the Standard & Poor’s 500 Index. So a volatility ETF may be useful as a short-term hedge against a portfolio or as a one-way bet on the market’s direction.

Like many other kinds of leveraged ETFs, volatility ETFs are meant to be owned over a very short period, often for just a day or two. Because they use derivatives, whose value tends to decline over time, volatility ETFs are often swimming against a fast-moving current. Because of this structure, volatility ETFs often do very poorly over time, as value leaks out of the fund.

Volatility funds may also technically be exchange-traded notes (ETNs), which is a somewhat different structure from ETFs, but may still track the volatility of the market.

Best volatility funds

iPath Series B S&P 500 VIX Short-Term Futures ETN (VXX)

This ETN provides exposure to S&P 500 VIX Short-Term Futures Index Total Return. Because it’s an ETN, holders have no principal protection and own unsecured debt of the company sponsoring the notes, Barclays Bank.

—YTD return: -18.9%

—5-year returns (annualized): -50.1%

—Expense ratio: 0.89%

ProShares VIX Short-Term Futures ETF (VIXY)

This fund tracks the S&P 500 VIX Short-Term Futures Index, which follows a portfolio of futures contracts with a weighted average of one month until expiration.

—YTD return: -19.5%

—5-year returns (annualized): -50.4%

—Expense ratio: 0.95%

iPath Series B S&P 500 VIX Mid-Term Futures ETN (VXZ)

This ETN tracks the S&P 500 VIX Mid-Term Futures Index Total Return. Because it’s structured as an ETN, holders have no principal protection and own unsecured debt of the issuer, Barclays Bank.

—YTD return: -2.5%

—5-year returns (annualized): -5.0%

—Expense ratio: 0.89%

ProShares VIX Mid-Term Futures ETF (VIXM)

This ETF tracks the S&P 500 VIX Mid-Term Futures Index, which follows a collection of futures contracts with a weighted average expiration of five months.

—YTD return: -3.0%

—5-year returns (annualized): -5.8%

—Expense ratio: 0.94%

ProShares Short VIX Short-Term Futures ETF (SVXY)

This ETF tries to provide daily results that are one-half the inverse of the daily performance of the S&P 500 VIX Short-Term Futures Index. In other words, if this index rose 1% in a day, the fund would aim to fall 0.5%. If the index fell 1%, this fund aims to rise 0.5%.

—YTD return: –3.8%

—5-year returns (annualized): 12.9%

—Expense ratio: 0.95%

The pros and cons of volatility ETFs

Advantages of volatility ETFs

—Easy-to-access exposure to volatility: When the market gets rocky, traders may flee to volatility ETFs to take advantage of the increasing uncertainty in markets. So this kind of fund offers an easy way to quickly get access to that exposure.

—Hedge on a portfolio: A volatility ETF may offer the ability to hedge a portfolio over a short period of time, offering an asset that rises as most others fall.

—Price may spike quickly: When the market suddenly turns volatile, the price on some volatility ETFs may rise hundreds of percent in just a few days. So if they place a well-time trade, traders can earn many times their wager quickly.

Disadvantages of volatility ETFs

—Meant to be held for very short periods: Volatility funds are really meant to be held only for short periods, giving exposure to the short-term movement of volatility.

—Value tends to decay over time: Because of the use of derivatives in the structure, the price of volatility funds tends to decay over time naturally.

—Unattractive long-term returns: Buying and holding a volatility fund is unattractive, as value seeps out of the funds over time through futures contracts.

What to look for in an ETF

When investing in ETFs, it’s useful to look at a few aspects of each ETF so that you actually buy what you intended to buy. Here are three key things to look for:

—The targeted exposure: Volatility ETFs provide different exposures to the market, in terms of time frame (short and medium term), whether they perform inversely to what they’re tracking and whether they take a leveraged approach to magnify gains.

—The investment track record: You’ll also want to know the track record of the ETF. The track record can give you some idea of what to expect from the ETF. But volatility ETFs are designed to perform well only over short periods, so in many cases long-term returns look awful.

—The expense ratio: Pay attention to the expense ratio, which tells you how much it costs to own the fund annually as a percentage of your total investment in it.

How to invest in volatility ETFs

A volatility ETF can make it easier to profit if the stock market makes a sudden move lower or it may even help you quickly hedge a position over a short period of time. But some funds have more upside if volatility rears up, while short volatility funds perform well if the market remains calm, taking advantage of the time decay to profit. So it’s vital to know what exposure you want.

The ETFs listed above give traders a way to gain exposure to volatility, but how they invest is up to them. Traders can shoot for the moon with short-term volatility funds or take a more modest approach with medium-term funds or even take advantage of calm markets with short funds.

Traders will also want to understand why they’re using volatility funds and when they’re helpful. Volatility ETFs may be helpful over short periods, but their structure means that the typical fund declines in value over time. So they may be OK as a short-term hedge when the market suddenly encounters danger, but traders looking for a longer-term hedge will look elsewhere.

You can buy volatility ETFs at any of the best brokers for stock trading.

Bottom line

Traders looking to make a short-term bet on the direction of the market may decide to use a volatility ETF to express that view. But volatility funds have significant drawbacks and their value tends to decay over time, even if it spikes sometimes as the market volatility heats up.

(Bankrate’s Brian Baker contributed to an update of this story.)

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.

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