Fear in the stock market can mean profit, but know the risks

AP News
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Posted: Aug 04, 2016 3:42 PM

NEW YORK (AP) — For some investments, the sound of crashing stock prices and panic in the market is actually the sweetest melody.

These investments tie themselves to the VIX index, a measure that traders call the stock market's "fear gauge," and they've been in higher demand as markets have become bumpier. Investors poured more than $2 billion into volatility funds during the first half of the year, triple the amount they did 12 months earlier, according to Morningstar. But before joining the tide, it's important to know that these kinds of funds aren't for everyone, and they're certainly not leave-it-alone, long-term holdings.

"Unfortunately, most of those are not well suited to retail traders," says Randy Frederick, managing director of trading and derivatives at Charles Schwab. "I see a lot of people wasting their money buying volatility-related products to try to catch that next big spike in volatility."

Frederick says many investors enter these kinds of funds with the wrong expectations, and the wrong idea about how to use them. For one, don't expect a VIX fund to move just like the VIX. And don't expect to be rewarded for buying one and patiently holding it.

The VIX is called the "fear index" because it shows how much traders are worrying about big swings hitting the S&P 500 in the next month. It does that by looking at how much traders are paying for options on the S&P 500, which they use to shield themselves if they're anticipating more volatility.

The VIX tends to surge when stocks drop sharply, something that's been occurring more frequently due to the weak global economy and a long list of other concerns. The S&P 500 has dropped 2 percent in a day nine times over the last 12 months. It had just two such days in the 12 months before that.

On June 24, for example, the VIX spiked nearly 50 percent after stocks tumbled on the United Kingdom's vote to leave the European Union. So, wouldn't it be great to own something that rises with the VIX, if not to profit from schadenfreude then to help offset losses in the stock portion of a portfolio?

But volatility funds don't track the VIX, which is not an investable index. Instead, they're often investing in the VIX futures market, where traders bet on where the VIX will be in coming months.

That means volatility funds often don't move as much as the VIX itself. The ProShares VIX Short-Term Futures exchange-traded fund, for example, rose on June 24, but by only about half as much as the VIX.

To get closer to the VIX's performance, some funds use leverage to boost their returns. ProShares' Ultra VIX Short-Term Futures ETF, for example, tries to give double the daily change of its underlying index, and it jumped 44 percent on June 24.

It's these kinds of short-term pops that investors should be looking for. Investors in the fund, which trades under the symbol UVXY, are holding it for a week or less, on average, says Joanne Hill, head of institutional investment strategy at ProShares. They aren't planning to hold UVXY for the long term: The fund is down 99.999 percent over the last five years.

"When people decide to use these, they're not looking at this five-year chart of how they've performed," Hill says. "They're looking at the fact that last August, when the VIX moved up 135 percent, UVXY moved up" 159 percent.

One reason for the poor long-term performance is the way prices work in the VIX futures market. Contracts for far-off months are generally more expensive than for close-in months. And the fund is regularly selling close-in contracts and replacing them with farther-off contracts.

Hill says dollars tend to pour into funds like UVXY when the market is calm, an indication that traders are trying to buy low in anticipation of an uptick in volatility. She says selling is highest when volatility does strike.

"The appeal of getting volatility exposure is the same reason we buy insurance for our house," Hill says.

Volatility funds piqued the curiosity of Brian Jacobsen, who is chief portfolio strategist at Wells Fargo Funds Management, a couple of years ago. He bought one of the more complex ones he could find, "just to see what it was like."

"I rode it for about a week, and I threw in the towel because it was doing nothing like what I was expecting," he says.

Does he remember which fund it was? "I don't," he says. "I try to block it out."