Why Chasing Volatility With a VIX ETF Is Trickier Than It Seems

U.S. investors looking for positive returns had few options on Monday. Stocks tumbled while Treasury bond prices pared early gains. The U.S. dollar slumped and commodities of all stripes—including gold, a traditional safe haven—slid. 

One index that was in the green: the Cboe Volatility Index (VIX), which surged to its highest level since March 2020 amid Monday’s turmoil. 

Commonly referred to as the “fear index,” the VIX is a measure of expected stock market volatility that is calculated with S&P 500 options prices. It often spikes when U.S. stocks tumble. For that reason, it can be tempting to view the VIX as a hedge against market routs like Monday’s, but the index is technically impossible to invest in directly. 

Traders who want to use the VIX to offset equity losses may instead be tempted to use a VIX exchange-traded fund (ETF), though doing so comes with substantial risk.

How Do VIX ETFs Work?

In reality, “VIX ETF” is a misnomer. These funds actually hold VIX futures contracts and do not mirror the VIX the way equity ETFs almost perfectly mirror their underlying index.

VIX futures contracts price the market’s estimate of where the VIX will be on the date of the contract’s expiration. VIX ETFs hold a portfolio of monthly VIX futures contracts and, by rolling one-month contracts over to two-month contracts on a daily basis, maintain a weighted average of one month to expiration. 

VIX ETFs and the VIX follow a similar path, as can be seen in the chart above. However, because of the costs associated with rolling futures contracts every day, the ETFs’ returns inevitably lag the VIX over the long term. This is just one reason it’s generally not advisable to use VIX ETFs as a long-term hedge against stock market declines. 

Another reason the VIX isn’t a great long-term investment is that the index, unlike equity indexes like the S&P 500 and Dow Jones Industrial Average, tends to regress toward a long-term average, as shown in the chart below.

Due to the peculiarities of the VIX and indexes composed of futures contracts, the S&P 500 Short-Term VIX Futures Index, which underlies the ProShares ETF VIXY on the graph above, perpetually trends down. The index over the last 10 years has delivered annualized returns of about -45%.

What About Shorting the VIX?

Another option for those looking to trade the VIX is to buy a short VIX ETF, which is designed to return the inverse of VIX futures contracts.

Investors piled into the ProShares Short VIX Short-Term Futures ETF (SVXY), the inverse of the ETF visible on the graph above, amid Monday’s selloff. The ETF pulled in $336 million in one day, more than doubling its assets under management. On Tuesday, the ETF returned 9.5% as markets stabilized and the VIX plummeted.

It would be reasonable to expect that, if the value of VIX ETFs gradually erodes over time, an inverse ETF would offer steady and gradual appreciation. That’s generally true, but short VIX ETFs have exhibited significant volatility of their own.

In February 2018, SVXY dropped 90% in one day as an increase in volatility squeezed the ETF’s short positions. The carnage of that particular episode, commonly referred to as “Volmageddon,” was exacerbated by the concentration of short VIX positions in leveraged funds. In response, ProShares cut SVXY’s leverage by half, so the fund now returns -0.5x the daily return of the S&P 500 VIX futures index.

Still, the ETF is prone to dramatic drops that coincide with and often exceed the magnitude of stock selloffs. They’re therefore of little use to investors trying to offset losses like those seen Monday.