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By Sverre Rørvik Nilsen aka finansakrobat

What if you could invest in something that has retained all the worst qualities from different asset classes? Would you buy it?

Let me present what I think is the very worst investment in the world: VXX.

The VXX is an exchange-traded fund from Barclays that supposedly tracks Volatility Index (VIX) futures. This makes it possible for traders to get simple exposure to the frequently traded VIX futures without having to trade futures. Although the VXX might seem like a friendly cat that will cuddle up on your lap when you're watching television, the truth is that it is a hungry tiger that will eventually take your head off.

Unless you want to read more about how ETFs work, you may want to scroll down to the bottom of the article to find out why VXX is such a terrible investment.

An ETF Is Born

Before I talk about the VXX and how terrible it is, let me review how an ETF is born.

Step 1: An ETF manager (such as iShares) files an S-1 with the US SEC to create an ETF. You may remember seeing such a filing when the Winklevoss twins tried to and failed to launch a bitcoin ETF.

Step 2: The manager forms an agreement with an entity empowered to create or redeem ETF shares.

Step 3: The entity borrows the shares that will be the underlying assets in the ETF, often for a large institutional investor, such as a pension fund. These shares are bundled into creation units (usually consisting of 50,000 shares). This bundling is done so that transactions are tax free.

Step 4: The entity receives the ETF shares and can sell them to the public like a share.

Now you have an ETF. If there is large demand for the ETF, such as there once was for the gold ETF called "GLD," more assets can be added to facilitate more trading.

An interesting side note on GLD and gold is that during the boom, one could consider gold as a derivative of GLD instead of the other way around because such a large percentage of the global demand for gold came from this single entity. The demand for GLD probably played a substantial part in driving up the price of gold (and lately, driving it down again).

When ETF owners want to exit the ETF, they can do it in one of two ways. The first way is to sell it in the open market, which in real terms means to sell it back to the market maker. The second way is to redeem the ETF and receive the underlying assets. An overwhelming majority use the first method.

How VXX Works

The VIX, rather simplistically referred to as the Fear Index, is an excellent index to track the cost of options on S&P 500 Index stocks. But because the index is not tradeable directly, people trade VIX futures. The VXX is designed to track VIX futures, specifically S&P 500 short-term futures.

When the value of the VIX veers too much away from the underlying assets, the market maker will buy or sell large blocks to drive the price back closer to the underlying asset. When you graph and back test the VXX, the results show why it is such a terrible investment. The inherent time decay of VIX futures will constantly chip away at the value of the VXX.

Anyone who has traded the VXX on a particularly volatile day can attest to the subdued movements compared with the VIX. Because the VXX is tracking a whole host of VIX futures, it only tracks the VIX a little more than 50%, making it a rather poor vehicle to expose traders to volatility. So even in the short term, the constant time decay, the sometimes hard-to-understand movements, and the complex structure make it very hard to use the VXX as a trading tool. Despite the issues, many people still do use it. On a daily basis, about 50 million VXX shares change hands.

A Horrible Investment

Finally, let's get down to the details. Why is this such a bad investment?

The VXX is marketed as a short-term investment, but it's still interesting to note that the total inflows have been $6 billion since its inception in 2009, and the market cap is now $1.15 billion. The difference has been eroded away. I myself have traded the VXX, with very poor results. To write this post, I was inspired to a great degree by Vance Harwood at Six Figure Investing, and I think he summarizes the VXX in the best possible way: "The VXX is a dangerous, chimeric creature; it's structured like a bond, trades like a stock, follows VIX futures, and decays like an option. Handle with care."

How the Pros Trade It

The VXX is very much an amateur product that tries to emulate a more highly developed market that is normally available only to people who are "professional" traders (those who have passed aptitude tests and the like).

So, how do the pros get exposure to volatility? They do it in a number of different ways. Some of the instruments they use are traded on an exchange, such as VIX or the European equivalent, VSTOXX. Alternatively, they buy straddles, which are at-the-money call or put options. It goes without saying that the majority of investors can't trade straddles because it requires daily trading in the underlying instrument to make sure they realize the volatility.

Volatility indices, such as the VIX or VSTOXX, are traded via their futures contracts and options. These are cheap to trade and a position can be customized to fit an investor's risk-return profile. If investors trade these indices through options, they can have unlimited upside, a hedge against losses, or a hedge for a certain interval, such as for a volatility jump from 15% to 18%. Different types of instruments are traded OTC (over the counter), such as variance swaps or volatility swaps, which are bets on the difference between implied volatility and realized volatility. But to trade these instruments, you must be a professional investor.

Judging by how complicated it is for a pro to be exposed to volatility, it is not really that weird that such instruments as the VXX don't work very well. Maybe the moral of the story is that amateur investors really should not trade volatility.

Disclaimer: Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

Source: The Worst Investment In The World