Volatility ETFs: Trading VIX Products and Managing Portfolio Volatility in the UK

The stock market can be a wild ride for investors. In the past year, we’ve seen swings in global equities due to events like the US-China trade war, Brexit uncertainty, and geopolitical tensions. Managing downside risk and staying invested during high volatility can be challenging. However, new investment products offer tools for sophisticated investors to profit from market volatility or protect portfolios during storms.

In this article, we will provide an overview of volatility Exchange-Traded Funds (ETFs), which track indexes linked to the CBOE Volatility Index (VIX), explore some popular VIX ETFs available to UK traders, and discuss strategies for incorporating these products into a portfolio to help balance risk.

What are Volatility ETFs?

Volatility ETFs, also known as exchange-traded funds, are a specific type of investment vehicle meticulously designed to follow the performance of volatility indexes closely. These indexes, exemplified by the widely recognised VIX, gauge market expectations regarding the level of volatility anticipated in the next 30 days. They do so by analysing the options prices of S&P 500 stocks.

Investors, when foreseeing heightened levels of volatility in the future, may actively seek to hedge their portfolios or even engage in speculative activities by utilising VIX products. The versatility and potential benefits these ETFs offer make them an intriguing investment option and a tool that can be employed to navigate the ever-changing and unpredictable landscape of the financial markets.

Available Volatility ETFs in the UK

In the UK, investors can access several volatility ETFs that expose them to the VIX index. Notable among these products is the iPath Series BS & P 500 VIX Short-Term Futures ETN (VXX), which offers exposure to a daily rolling position in the first and second-month VIX futures contracts.

Another popular option is the ProShares VIX Short-Term Futures ETF (VIXY), which operates similarly. Investors need to realise that these ETFs are designed to replicate the performance of the VIX index for a single day. Due to this fact, they are typically more suitable for short-term strategies rather than long-term investments, as the impact of daily rebalancing can erode long-term returns. Before investing, individuals must deeply understand these products and consider how they fit into their overall investment strategy.

Strategies for Managing Portfolio Volatility

When considering adding volatility ETFs to a portfolio, investors should clearly understand their risk tolerance and investment goals. Here are some strategies to consider when managing portfolio volatility with these products.

One of the primary uses of volatility ETFs is as a hedge against market downturns. By holding a short position in VIX products, investors can potentially offset losses in their equity holdings during periods of high volatility. However, this strategy requires careful timing and monitoring as the performance of these ETFs may deviate from that of the VIX index due to factors such as contango (when futures contracts are more expensive than spot prices) or backwardation (the opposite).

Another approach to managing portfolio volatility is the tactical allocation of assets. Investors might increase their allocation to Volatility ETFs when market indicators suggest a rise in volatility is imminent or during economic uncertainty. Conversely, during stable market conditions, reducing exposure to VIX products can help avoid the costs associated with their potentially damaging long-term performance due to the mentioned daily rebalancing.

Investors can also opt to use volatility ETFs for diversification. VIX products can complement a diversified portfolio by offering a potential buffer against market declines, including assets generally uncorrelated or inversely correlated with the broader market. However, investors must be aware of the complexity and nuances of these financial instruments. Professional advice should be sought to ensure that such strategies are consistent with the investor’s objectives and risk appetite.

Risks and Considerations

Volatility ETF trading carries risks. As with any investment, there is always the potential for capital loss. Using these products requires a deep understanding of their operation and underlying components. Daily rebalancing can result in significant costs for long-term investors, and as mentioned earlier, contango can lead to underperformance relative to the VIX index. Additionally, these ETFs are designed to track short-term market volatility and may not be suitable for long-term investment objectives.

Furthermore, leverage, common in some VIX products, can significantly amplify losses during periods of high volatility. As with any investment decision, thorough research and consultation with a financial advisor are crucial to determine if these products suit an individual’s investment goals and risk tolerance.

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