VIX ETF Investors Should Scrutinize Their Hedge

by: Tom Lydon

Investors are taking a closer look at volatility exchange traded products after the sharp move lower in VelocityShares Daily 2x VIX Short-Term ETN (NASDAQ:TVIX).

Many investors have been buying exchange traded funds tied to futures contracts on the CBOE Volatility Index, or VIX. They likely bought the volatility products as insurance against a market pullback.

Some investment advisors, though, have been warning against these funds' suitability for the average retail investor.

VIX-related funds, like the iPath S&P 500 VIX Mid-Term Futures ETN (NYSEARCA:VXZ), ProShares VIX Short-Term Futures ETF (NYSEARCA:VIXY) and ProShares VIX Mid-Term Futures ETF (NYSEARCA:VIXM), have attracted record inflows this year as wary investors try to hedge against market volatility after being burned over last summer, reports Ajay Makan for the Financial Times.

"I'm not surprised at the interest in these products, given many investors' fear that volatility won't stay this muted for long," Steve Davenport, director of equity risk at the asset manager Wilmington Trust, said in the article.

However, these investments have been losing as volatility in the equities market dips back to their historical averages and fund providers have been purchasing costlier future-dated VIX contracts after rolling near-term contracts that are about to mature.

"As more money is invested in these products, the operators have to buy up more VIX futures contracts and the cost is passed on to investors," Nikolaos Panigirtzoglou, a senior analyst at JPMorgan, said in the Financial Times article. "The investors buying these products are typically retail investors - you wouldn't see a hedge fund using a strategy like this for downside protection."

Fund providers would have to take on more futures contracts as investors throw more money into the VIX funds. For instance, the iPath S&P 500 VIX Short-Term Future ETN (NYSEARCA:VXX) saw its shares outstanding increase rapidly.

"The VIX futures market is very thin," Davenport, added. "People on the other side of the trade know that the banks operating these funds have to cover their positions and can price accordingly."

Max Chen contributed to this article.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.