Did Volatility ETFs Drive the Market’s Selloff?

These funds have no place among everyday investors

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Rising U.S. Treasury yields were widely cited as the spark that ignited early February's sharp selloff in stocks. But the real damage, in my view, was caused by a handful of arcane exchange-traded funds and other products that let traders place giant wagers on the direction of the CBOE Volatility Index, known by its symbol VIX and often called the “fear index.” The good news: The selloff already may be finished. But regardless of whether it’s behind us, you certainly should stay away from these dangerous volatility ETFs.

The stock market’s volatility had been incredibly low the past two years as the market ambled placidly higher. Traders placed bets that the low volatility would continue. These bets were incredibly profitable. The ProShares Short VIX Short-Term Futures ETF (SVXY, $11.34), for instance, gained 80.3% in 2016 and 181.8% last year.

Little more than a week ago, the market suddenly turned volatile — and the funds imploded. ProShares Short VIX Short-Term Futures lost a hard-to-believe 89.7% last week. A similar exchange-traded product, the VelocityShares Daily Inverse VIX Short-Term ETN (XIV, $5.34), plunged 95.3%. The VIX itself rose almost 70%.

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Why? As the bets on continued low volatility soured, traders dumped them en masse. Billions of dollars flowed out of the funds and VIX futures. The volatility ETFs’ prices cratered, putting massive buying pressure on futures and funds tied to rising stock-market volatility.

Most of the buying was “short covering.” When a trader or fund wanted to bet that the VIX would decline, it borrowed securities that would go up with rising volatility in the hopes of returning the borrowed shares at a lower price. When the bet on continued low volatility went dramatically wrong, the shorts were forced to buy securities tied to a rising VIX, thus propelling the fear index ever higher.

As that index soared, stocks unsurprisingly tanked. The VIX and the stock market typically move in opposite directions; said differently, the more volatile the stock market is, the more likely stocks will fall.

What’s more, traders who suffered big losses on their short VIX bets had often bought these funds with borrowed money. To repay the money, they sold stocks and other securities, accelerating the market selloff.

Have the sellers already exhausted themselves? Huge rallies Friday and Monday suggest that may be the case. No one knows how much margin (borrowed money) these traders employed in short-volatility VIX funds and other instruments, so some may continue to unwind their trades. But the damage done last week could well be the worst of it. One big caveat: Once a selloff starts, it can continue for a variety of reasons regardless of what initially triggered it.

The Aftermath of the Volatility Spike

At least one volatility ETF — VelocityShares’ XIV, which is issued by Credit Suisse (CS) — plans to liquidate on Feb. 21. Its prospectus allows it to close down after any one-day loss of 80% or more. Fidelity last week halted purchases of three volatility-focused funds.

I’d like to see them all closed. The Securities & Exchange Commission, in my view, should never have allowed these funds to be sold — especially to ordinary individual investors. They’re extremely volatile, serve little if any useful purpose, and as we saw, can cause real harm to the markets.

How many investors read the prospectus language that allowed the Credit Suisse ETN to fold after a one-day loss of 80%? The answer likely is “precious few.”

Even fewer probably understand the problems of daily compounding, which all these instruments employ because they set the same percentage of leverage at the start of each trading day. The prospectuses tell investors that these funds are to be used for one day or less. But, of course, few read the fine print, and many of those who do don’t heed the warning.

Daily compounding means investors are likely to lose money in these funds if they invest for very long, especially if their underlying index is volatile. The problem is simple arithmetic. Say you invest $1,000 in one of these funds and it rises 20% in one day. You then have $1,200. Suppose the fund loses 20% the next day. You don’t have $1,000; instead you have only $960. That process can erode your investment over time. You can make money over time in these funds, but only if their underlying index continues in pretty much one direction.

Plenty of leveraged funds using daily compounding have lost money in years during which the index they tracked (without leverage) finished in the black. For example, the Direxion Daily MSCI Emerging Markets Bull 3x (EDC), designed to deliver three times the daily return of the MSCI Emerging Market Index, has lost an annualized 2.7% over the past five years while the index has gained an annualized 4.6%.

If a couple of Wall Street traders spotted two birds perched on a wire, they’d likely bet on which bird would fly off first. These leveraged and inverse funds, in my view, do about as much good for economy as a bet on which trader wins the bird bet.

But, as we’ve seen, the funds can do enormous damage.

Steven Goldberg is an investment adviser in the Washington, D.C., area.

Steven Goldberg
Contributing Columnist, Kiplinger.com
Steve has been writing for Kiplinger's for more than 25 years. As an associate editor and then senior associate editor, he covered mutual funds for Kiplinger's Personal Finance magazine from 1994-2006. He also authored a book, But Which Mutual Funds? In 2006 he joined with Jerry Tweddell, one of his best sources on investing, to form Tweddell Goldberg Investment Management to manage money for individual investors. Steve continues to write a regular column for Kiplinger.com and enjoys hearing investing questions from readers. You can contact Steve at 301.650.6567 or sgoldberg@kiplinger.com.