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The topic of "volatility" has gotten some prominence again, especially since the US stock market suffered a decline of more than 5% at the beginning of this year. (Mind you that a 5% or even a 10% decline in stocks is nothing unusual. It is more unusual to have a steady rise in stocks - and we saw that happen between the summer of 2011 and the end of 2013, when there was no stock market decline greater than 10%.) In this environment, any investor can trade on the resurgence of volatility, especially if they take advantage of the prolific number of ETPs, or Exchange Traded Products like the iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX), the most actively traded volatility ETP, or the iPath S&P 500 VIX Mid-Term Futures ETN (NYSEARCA:VXZ). My advice? Don't!

Arguments go back and forth between advocating for volatility ETPs and arguing against them making it quite difficult for one to figure out what to do. It makes sense to list the purpose of the ETPs and to go over the reasons to trade them or invest in them. ETPs are primarily used for (1) portfolio diversification, (2) tactical asset allocation, and (3) speculation.

Portfolio Diversification

The correlation between asset classes is an essential factor when constructing a strategic portfolio. As a general rule, the lower correlation an asset class has with other assets, the more beneficial it is to include it in one's portfolio, and the more diversified a portfolio will appear. So much for the theory. In practice, correlation is not a static property, and usually increases in times of upheaval, when most markets go "topsy turvy" at once. But it is exactly at those times that you would want to reap the benefits of diversification.

The VXX is a widely available volatility instrument that has a negative correlation with the S&P 500 on whose volatility the VXX is based. The correlation between the VIX volatility index and the S&P 500 stock index has been around -0.80 during the last 5 years, making a product based on the VIX volatility index a prime candidate for portfolio diversification. Sophisticated investors can follow an intricate model that includes volatility as an asset class, but things are not as straight-forward for retail investors who have limited choices (like VXX or VXZ) for including volatility in their portfolio.

VXX's assets are invested in futures contracts, which lose value over time. Hence, the VXX also loses value over time even if the underlying index (i.e., a volatility index) stays the same. This loss of value is true for all ETPs, but it is very pronounced with the VXX. This loss in value also makes it very expensive to invest in VXX as part of a strategic asset allocation. Sure, it counters swings in the portfolio, especially in tough times, and it makes the return of an overall portfolio less volatile. But this safety comes at such a high price that the VXX has been called the "Worst Investment in the World." Therefore, it is probably best that retail investors leave investing in volatility products to sophisticated pros who fully understand such well-written articles like "The Value of Volatility ETPs."

Tactical Asset Allocation

Tactical asset allocation involves a shorter time horizon than strategic asset allocation, because tactical asset allocation tries to take advantage of shorter-term moves to boost the overall return of the portfolio. Often a number of derivative instruments like options, futures, and ETPs are used to adjust the asset allocation for shorter-term purposes. When volatility is expected to rise in the near term, investors can use VXX as one such instrument to make such adjustments.

But it has been shown that tactical asset allocation adds to a portfolio's return only at the margin, since about 90% of a portfolio's returns are derived from its strategic asset allocation. If you use VXX in your tactical asset allocation, you have to deal not only with the particular challenge of trying to work the margins here, but also with the fact that you have to get the precise timing of the investment in VXX right. (Keep in mind that VXX loses value quickly even if the underlying index does not change.) Unless you use a very sophisticated and disciplined tactical asset allocation model, I'd say that VXX is too expensive to use as a hedging or diversification instrument for time horizons of a year or less.

Speculation/Trading

Last, let's look at the shortest time horizon, namely short-term trading and speculating. This realm of financial markets has its own rules, where even with the rules basically anything goes. Traders have to be exceedingly disciplined if they want to make money on short-term moves, whether they trade in VXX or any other financial instrument.

Nevertheless, let's complete this analysis and take a look at the relationship between VXX and SPY. (As stated above, VXX is based on the volatility of the S&P 500 stock index, which is the underlying index for the oldest ETF in the US, namely SPY, formerly known as SPDR.) The daily returns of VXX and SPY are negatively correlated to the tune of -0.81 based on the most recent 5-year data. Thus, VXX normally rises when SPY falls and vice versa. The R-Squared of the daily returns is 0.656, meaning that 65.6% of VXX's daily returns can be explained by the daily returns of SPY.

The correlation and R-Squared are certainly not perfectly aligned but they are linked so closely that one might say a trading call in VXX and SPY is almost interchangeable. Sure, the VXX's daily returns are more than three times as large as the SPY's, which gives a good speculator more bang for his buck, but the same purpose is served by leveraged S&P 500 ETPs (whether long and short). Perhaps more importantly, none of the S&P 500 ETPs lose value over time quite as quickly as VXX does, which is why an S&P 500 ETP gives traders more room for error.

In sum, volatility ETPs are most suitable for (A) sophisticated investors who construct intricate (strategic and/or tactical) asset allocation models and (B) highly disciplined traders. All others should skip trading volatility ETPs like VXX and VXZ and instead focus their efforts on correctly gauging the direction of the market by using only (expected) volatility as an input factor in their overall analysis.

Disclosure: I am long SPY. Nosara Financial Planning, Inc. ("NFP") and some of its clients hold positions in exchange traded funds (ETFs). At the time of publishing, NFP and/or its clients hold long positions in SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Disclaimer: No information accessed through this website or through NFP's website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision.

Source: To Trade A Volatility ETP Or Not To Trade A Volatility ETP?