What You Don't Know About Many ETFs

by: Tunnel River Capital


Why many ETFs are not as good as you think they are - an introduction to the concept of drag.

VIX is the best volatility product.

Why you will probably lose money buying VXX, VIIX or UVXY.

Before beginning I would like to highlight one fact about VIX. There is no 'regular shares' of VIX, it only has options, this is why its peer products are even relevant.

To summarize, this article is about the concept of 'drag' in ETFs and also why VIX is a better product for options traders, as opposed to many other volatility products. However, for non-options traders I believe this article to be extremely important as to why volatility products that attempt to track the VIX index are not extremely good at it and why you might want to consider different hedging strategies. Finally, I explain why you should never hold these volatility products for the long term.

We are in a market where having a diversified portfolio is becoming increasingly important to protect oneself against global volatility. With de-globalization becoming a more common phenomenon and terms like 'secular stagnation' being used, there are many risks at play in today's market. One of the most popular ways to hedge against long equity positions is to get long volatility products such as VIX, UVXY, VXX and VIIX. These securities are inversely related to the S&P and can profit nicely when the market drops. Volatility securities are very liquid and are extremely popular in the options market. You can also buy regular shares in all of the tickers listed previously, except for VIX which only has options. However, there is a lot people do not know about these products, especially the differences between them. Three of the four securities listed above are ETFs affected by a concept called 'drag' which is one reason I believe them to be poor hedges. The one out of the four that is not affected is VIX. It amazes me how little 'drag' is talked about, as it has pretty large implications. Let me introduce to you to the concept of Drag and how VIX is fundamentally very different from UVXY, VXX, VIIX and many other volatility products.

The Prices of UVXY, VXX and VIIX are priced off of the volatility futures - /VX. As the popularity of ETFs has grown in recent years, some ETFs are now completely based off the price of a specific Futures contracts. VXX, UVXY and VIIX are examples of this type of ETF. In the futures market the contracts that are traded have expirations. /VX (volatility future) has contracts for almost every week and month. To constantly stay trading a type of Future, these ETF portfolios have to 'roll' their contracts in their portfolios before they expire. This means they have to sell the front month contract (closest month to expiration) and buy the contract in the back month (following expiration month). To do this the portfolio must sell their current positions and buy them at the next month's HIGHER PRICE, automatically negatively affecting the ETF price. Because of this process which MUST occur every time the contracts in the portfolio are expiring, a negative 'drag' occurs in the stock price. This outcome can easily be seen in 4-year charts.

UVXY 4-Year

VXX 4-Year

These charts say it all.

Now, the reader might ask - Why does this chart indicate UVXY was thousands of dollars per share a few years ago? That is because these charts are adjusted for reverse-stock splits. Since the 'drag' that occurs on these ETFs trends the price towards zero, the ETF must do frequent reverse-share splits to maintain a reasonable price. Here is UNADJUSTED chart of UVXY over the past few years.

UVXY Unadjusted

Let me emphasize this again, those incredibly large spikes are not drops in the market. They are the portfolio reverse-share splitting. You DO NOT profit off these spikes - that is the point of the adjusted charts.

However, now let me compare this to a 5-year chart of VIX. (There is no adjusted chart for VIX, it has no shares to reverse-split.)

VIX 4-Year

VIX stays within a confined range because unlike these ETFs it is priced off the SPY options prices, it is not based off /VX futures! This is why VIX is fundamentally different and is not affected by the concept of 'drag' like its peers. As you can see, VIX is a much better option to trade - the volatility ETFs are built to go to zero!

One argument against these charts and that is PRO the usage of these alternative volatility products - might say the hedges are very short term, so the concept of 'drag' does not matter as much. It might not matter 'as much' but it definitely still plays an important role. Let's take a close at how drag affects these products in a 3-month span.

Date Price of UVXY Price of VXX Price of VIX
April 1st, 2016 $18.22 $17.12 $13.10
Current Price $6.08 $11.15 $11.79
Price Depreciation -67% -35% -10%

As you can see, volatility has come down in the past few months, however - the price depreciation in VIX was far less than its peers affected by drag, even in this shorter time horizon.

Another reason people differ to securities like UVXY is because they are seen as more volatile than VIX and capable of better returns. However, this is not always the case. VIX actually frequently makes similar sized moves to UVXY. Here is a recent example of the returns if you perfectly timed the most recent spike in volatility.

Date Price of UVXY Price of VXX Price of VIX
June 6th, 2016 $9.74 $12.86 $13.65
June 26th, 2016 $14.99 $16.92 $25.76
Price Appreciation 54% 32% 89%

In the most recent spike in volatility, VIX by far had the most price appreciation. UVXY makes many similar sized moves, but the notion that it is capable of much better returns is simply false.

As you can see many of these popular ETFs are actually horrible long-term hedges. The only scenario where they MIGHT be useful, is for shorting. Shorting volatility is extremely risky as volatility spikes very quickly and I would never recommend it. However, if you are someone who likes the risk of shorting volatility why wouldn't you short a product that is already designed to head to zero?

I would also like to add that these volatility products are not the only ETFs affected by drag - that is why it is so important. USO, which is priced off oil futures is also affected by drag. However, /VX futures are in contango around 85% of the time. This means futures price is heading up into the future, implicating the farther-expiration future contracts are more expensive. Being in contango 85% of the time is far more than other futures, which makes the drag in volatility ETFs FAR more substantial compared to ETFs such as USO. However, in the long term, drag will have an effect on every ETF, even if the effect is less substantial.

With the global economy facing increasing uncertainty and some foreseeing an era of secular stagnation, the importance to hedge against long equity positions is more important than ever. However, investors should understand the products they are hedging with and the pros and cons to all of them. Unless you are an active trader who fully understands the pricing of volatility ETFs then I would suggest only hedging with VIX as a volatility product (for options traders only). For non-options traders - I would just make sure to hedge long equity positions in another way. If you do really want to trade volatility products, I would just advise you keep it VERY short term, as you have seen the long-term effects.

In conclusion, be careful with buying ETFs that are based off the prices of futures contracts. Though it is not as substantial - drag still occurs in non-volatility ETFs. This article should show that many ETFs are designed to work against you in the LONG term. And some ETFs, like volatility ETFs, are designed even worse to work against long positions. My advice is to find some different way to hedge your equity positions in the long term - and if you trade options, there is no reason not to be trading VIX!

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

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.