Decoding Volatility-Linked Exchange Traded Products (ETPs): A Deep Dive into Their Hidden Risks and What Investors Need to Know

While no single definition describes what a complex investment product is, it is generally understood that these are financial products and instruments, including leveraged and inverse exchange-traded funds (ETFs) and Notes (ETNs), and other derivative securities (collectively, referred to as exchange-traded products or ETPs), that pose unique and significant risks to investors due to their intricate and difficult-to-understand structures and the potential for significant losses.

Complex investment products have unique features and risks that are not always apparent. They might include embedded derivatives, utilize leverage, provide non-linear payoffs, or offer inverse performance relative to an index or underlying assets. Misunderstandings about how these instruments work, how they should be deployed, and the risks associated with them may lead to substantial financial losses.

Volatility-linked products have garnered significant attention for their ability to provide exposure to market volatility. While these products may appeal to those seeking to hedge against market downturns or speculate on volatility spikes, their complexity and risks raise important suitability concerns, especially for retail investors. They are a prime example of complex investment products that are difficult to understand and carry significant risks.

Volatility-Linked Exchange Traded Products

Non-traditional ETPs are often designed to return a multiple of an underlying index or benchmark, the inverse of the benchmark, or both over one trading session, which typically lasts a single day. These ETPs frequently employ leverage to seek to multiply the daily return of the underlying index, usually by two or three times. Volatility-linked ETPs are a type of non-traditional ETP designed to track the performance of volatility indices, such as the CBOE Volatility Index (VIX), commonly referred to as the "fear gauge" of the stock market. However, since the VIX cannot be directly bought or sold, these ETPs strive to replicate the VIX's movements by holding a portfolio of futures contracts on the index.

The value of these ETPs is primarily derived from the movement in volatility. For example, when market volatility spikes, the value of a volatility-linked ETP may increase. Conversely, when volatility declines, the ETP’s value may decrease. Importantly, however, multiple characteristics, including their volatility, compounding, contango, and value decay, price decoupling make them unsuitable for retail investors with buy-and-hold strategies in mind or who plan to hold their investments for an extended period.

Structural and Market Risks Involved with Volatility-Linked ETPs

There are numerous risks associated with investing in these speculative instruments and their prospectuses are littered with disclosures about them. As FINRA noted in its Regulatory Notice 09-31, the performance of these non-traditional ETPs over periods longer than a single trading session “can differ significantly from the performance (or inverse of the performance) of their underlying index or benchmark during the same period of time” due to the effect of compounding.

Indeed, for volatility-linked ETPs, the effect of compounding can lead to substantial deviations from the expected performance over longer periods. These products are designed to achieve their stated investment objectives on a daily basis, which means that holding them for longer than a day can lead to performance that differs significantly from the index they are tracking.

In addition to the de-coupling in performance, compounding also causes value decay. And while compounding affects all investments, its impact is much more severe for volatility-linked exchange-traded products such as VXX compared to traditional investments like mutual funds (in fact, compounding generally works in favor of mutual fund investors due to the long-term upward trend of financial markets). The key reason is that VXX and similar products experience compounding in a highly volatile and path-dependent, mean-reverting manner, which leads to sustained and relatively rapid value decay. The chart below, showing VIX Index performance for the past five years, visually demonstrates the pattern of high volatility, path-depended, and mean reverting performance of the VIX Index.

The next chart demonstrates how compounding impacts the price trajectory of volatility-linked products like VXX, assuming VXX returns sequence of alternating +10% and -10% changes over 30 days. You can now clearly see how the VXX compounded price trends lower – experiencing value decay - due to volatility. When the price drops after a loss, the subsequent percentage gain applies to a smaller base, leading to a lower final value.

In addition, these ETPs are also affected by the futures market conditions, particularly contango, where longer-dated futures contracts are more expensive than those nearing expiration. As a result, VIX ETPs can suffer from negative roll yield, where the cost of rolling contracts eats into the fund's returns. This is especially problematic during periods of low or declining volatility, where the VIX remains subdued, but the cost of maintaining the futures positions erodes the ETP's value.

As the prospectus for the VXX aptly observed, “absent stressed market conditions, VIX futures have historically traded in ‘contango’ markets, and VIX futures have frequently exhibited very high contango in the past, resulting in a significant cost to ‘roll’ the futures.”  As explained above, when the ETP rolls over its futures contracts, it may have to sell the current contract at a lower price and buy the next contract with longer maturity at a higher price, resulting in a so-called negative roll yield. Over time, this can significantly erode the value of the ETP. After all, buying high and selling low has never been a winning trading strategy.

The graphic below demonstrates the contango effect in futures contracts. The red dashed line represents the spot price, which remains constant, while the blue line shows the futures prices that increase over time as the expiration date extends. This upward slope illustrates the contango effect, where longer-dated futures contracts are more expensive than shorter-dated ones, leading to potential value erosion in products like VIX ETPs when they roll over contracts.

The persistent existence of the contango effect in the futures markets causes significant and sustained declines in the value of volatility-linked ETPs. Indeed, this phenomenon is so well-evidenced that the issuers of these types of ETPs often disclose and warn in their prospectuses that “the long term expected value of [these investments] is zero” and holding them “as a long term investment” will result in losses of “all or a substantial portion of the investment.”  See, e.g. iPath® Series B S&P 500® VIX Short-Term FuturesTM ETN Prospectus.

To illustrate this point further, consider Barclays iPath Series B S&P 500® VIX Short-Term Futures ETN trading under the symbol VXX. According to the most recent data, the VXX lost a significant portion of its value since its inception and, as the performance chart below shows, the VXX value is persistently declining since its inception, having been interrupted only very sporadically during significant market disruptions.

In addition to these structural risks, volatility-linked ETPs are inherently risky due to the volatile nature of the underlying indices they attempt to track. The value of these ETPs can fluctuate widely in short periods, leading to potential rapid gains or losses. Successfully investing in volatility-linked ETPs often requires accurate market timing, which is difficult for even the most experienced investors. Misjudging the timing of market movements can result in substantial losses, as volatility can spike or subside rapidly. The leveraged nature of many VIX ETPs means that small movements in the VIX can lead to outsized losses. This characteristic makes them unsuitable for investors with low-risk tolerance or those who cannot afford to lose their entire investment.

Suitability Concerns for Retail Investors

Given their complexity and inherent risks, volatility-linked ETPs are generally unsuitable for most retail investors. These products demand a deep understanding of futures markets, volatility indices, and market conditions that influence their performance. Many retail investors lack the necessary knowledge to understand the complex mechanisms driving these investments, such as contango, leverage, and compounding effects, which can lead to unexpected and significant losses. Moreover, the need for precise market timing adds another layer of difficulty, further misaligning these products with the investment strategies of most individual investors, who typically benefit from long-term, stable investments.

While volatility-linked ETPs can be effective tools for hedging or speculative trading, their risks far outweigh their benefits for the average investor. If you or someone you know has suffered financial losses or was defrauded as a result of investing in these complex products, AMW Law, PLLC can help. Our firm is committed to protecting investors’ rights and holding financial institutions accountable for improper recommendations or misrepresentations related to these investments. Contact us today to discuss your legal options.