Plunging stock markets cause anxiety for many investors, but for some they are the source of juicy profits. For those investors with a good sense of timing and an appetite for risk, there is opportunity in exchange-traded funds (ETFs) whose returns are tied to volatility. When markets turn volatile, as they have in recent weeks, the rewards can be great.

“Activity has spiked in our volatility ETFs, but it’s important to remember they are speculative investment tools, not long-term investments,” says Steven Hawkins, co-CEO and chief investment officer at Toronto-based Horizons ETFs Management (Canada) Inc. “They can also be used as a partial hedge against market conditions.”

The CBOE volatility index (VIX) was created by the Chicago Board Options Exchange. This index is considered a key measure of market expectations during rolling 30-day periods, based on prices for S&P 500 put and call options. Although the VIX often is called the “fear index,” it is a measure of volatility in either direction, including to the upside.

Premier barometer

The VIX is considered to be the world’s premier barometer of investor sentiment, and can fluctuate wildly. The VIX is quoted in percentage points, and values below 20 are generally associated with less stressful times in the market. In late August, the VIX went as high as 53.29 – its highest level since January 2009. The all-time highest VIX intraday value was 89.53, reached in October 2008 during the financial crisis. Because the VIX is not a tradeable index, volatility ETFs are tied to the S&P 500 VIX short-term futures index, which uses derivative instruments such as futures contracts to create a similar return.

“Investing in volatility ETFs can be extremely volatile, and they are not for the faint of heart. When you see the trends reversing, you need to get out quickly, ” Hawkins says.

There are several volatility ETFs trading on U.S. stock exchanges, including inverse volatility ETFs that increase in value when volatility declines. In Canada, Horizons is the only provider of volatility ETFs, and the company offers three products: Horizons BetaPro S&P 500 VIX Short-Term Futures ETF, which tracks the daily performance of the S&P VIX Short-Term Futures Index ETF; Horizons BetaPro S&P VIX Short-Term Futures Bull Plus ETF, which offers two times the daily performance of the underlying index; and Horizons BetaPro S&P 500 VIX Short Term Futures Inverse ETF, which offers one times the inverse of the index’s daily performance.

During the month of August, while the S&P 500 fell by 4.9%, Horizons’ Bull Plus VIX ETF was up by 171% and the regular VIX ETF was up by 71%, while the Inverse VIX ETF was down by 47%. (All ETFs and the index are hedged back to the Canadian dollar).

“When markets are rising and times are good, volatility tends to fall. But in a bearish environment, it tends to spike,” says Dan Hallett, vice president and principal of HighView Financial Group in Oakville, Ont. “Volatility-related ETFs can provide protection in a market free fall, but cannot be held as long-term protection against a market drop, as they could lose value in the interim.”

Volatility ETFs are not directly correlated to market indices, but often will react ahead of the markets. Typically, markets become more volatile as they head into bearish territory, and volatility declines as they rise, Hawkins says. For example, until this past August, markets had been gradually rising for a period of several years without any major drops, and there was little opportunity in regular VIX-related ETFs. However, the inverse versions – which do well when volatility fades – offered the chance to make gains.

Monitor daily

Horizons warns in its prospectus that the VIX-related ETFs aren’t intended to be held for the long term, as the underlying index tends to revert to a historical mean. Investors should monitor their ETFs daily.

“It’s important to get the timing right,” says Daniel Straus, head of ETF research and strategy at National Bank Financial Ltd. in Toronto. “Someone who doesn’t understand futures and options may be better off in another type of product if they want long-term protection against a market drop.”

But, if there is a short-term event with the potential to rattle markets, that can present an opportunity. For example, trouble in Asian markets, which open several hours ahead of North American markets, or an expectation that an interest rate hike on a certain day may spook investors, could ignite volatility. On Monday, Aug. 24, after China had devalued its currency and set off a domestic stock market plunge, the U.S. market later fell by 1,000 points intraday, later soared by 900 points and ended the day down by 588 points – creating huge profits in volatility strategies for some fast-moving traders.

Because the value of volatility ETFs can swing quickly, investors seeking to protect their assets against a market decline may be better off in ETFs that provide a constant hedge. Examples of these include Purpose Tactical Hedged Equity Fund, which invests in a portfolio of U.S. stocks while hedging the fund’s exposure with options; or Purpose Multi-Strategy Market Neutral Fund, which invests in long and short positions across multiple asset classes, including equities, fixed-income, commodities and currencies. Both ETFs are sponsored by Toronto-based Purpose Investments Inc.

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