The stock market broke down on Thursday, sending major benchmarks sharply lower. Market participants seemed to lose the confidence they'd built up over the past several weeks, as recent economic data cast doubt on whether a recovery is really in the cards.
Even though markets didn't respond immediately to the Federal Reserve's policy statement Wednesday afternoon, further contemplation seemed to make investors more bearish about the immediate future. The Dow Jones Industrial Average (DJINDICES:^DJI), S&P 500 (SNPINDEX:^SPX), and Nasdaq Composite (NASDAQINDEX:^COMP) all suffered immense declines.
Today's stock market
|Index||Percentage Change (Decline)||Point Change|
Data source: Yahoo! Finance.
As we saw Wednesday, the bond market made lemonade from the stock market's lemons, as several bond ETFs posted solid gains for the day. But volatility ETFs were the big winners from the bad day on Wall Street. Below, we'll look at why these specialized investments did well and what it means for the future.
Making money when the market plunges
Volatility ETFs are geared to track measures of stock market volatility, most typically the CBOE Volatility Index or VIX for short. The VIX looks at the prices of various index options on the S&P 500, seeing what investors are willing to pay for various call and put options and analyzing what that implies about expectations of future price moves. In general, when markets move sharply lower, the VIX gains ground. When markets settle down and move higher, the VIX often falls.
Today, the VIX soared almost 50%, and that created big gains for the ETFs that use various VIX futures contracts to get exposure to volatility. The iPath S&P 500 VIX Short-Term Futures ETN (NYSEMKT:VXX) climbed 34% on the day. Leveraged volatility plays like the VelocityShares Daily 2x VIX Short-Term ETN (NASDAQ:TVIX) did even better, rising 66% on Thursday. Similarly, the ProShares Ultra VIX Short-Term Futures ETF (NYSEMKT:UVXY) split the difference, putting in a 50% rise.
Let the long-term buyer beware
Volatility ETFs are designed to be short-term plays on market turbulence. When markets move sharply for long periods of time, the ETFs are most effective. Repeated ups and downs, however, weigh on overall performance.
For instance, the iPath volatility ETF almost quintupled in price between Feb. 20 and March 18, as the stock market moved almost straight down. Leveraged volatility plays did even better. But when stocks recover, the damage to volatility ETFs can be brutal. Before today's market drop, the iPath fund had lost well over half its value since mid-March.
In the long run, volatility ETFs haven't done their shareholders any favors. The iPath fund posted losses every single year from 2009 to 2017, and dropped hard in 2019 after managing to claw back a little ground in 2018.
Volatility ETFs look like obvious bets on days when the market takes a dive. Unfortunately, their longer-term track records leave much to be desired. Would-be investors shouldn't let a single day's performance influence their investing strategies.