There has never been a better time for young people to start investing, and many have turned to the Robinhood mobile app to buy their first shares. The stocks that Robinhood investors are buying have inspired a lot of debate about their suitability for people who are new to the market, but it’s still good to see newcomers embrace the idea of their money working through investment.
However, thousands of Robinhood investors are actually reviewing the shares. Rather than waiting for good times ahead, these bearish app users have focused their attention on ETFs that are tied to stock market volatility. These volatility ETFs generally increase in value when stocks fall, but their long-term behavior leaves much to be desired.
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The idea behind volatility ETFs
Fund companies designed volatility ETFs to track what’s known as S&P volatility index (VOLATILITY INDICES: ^ VIX), or the VIX for short. The VIX is referred to by many market participants as the “Fear Index” because it tends to rise when the market falls sharply, but then falls when the market recovers.
Volatility ETFs have different characteristics, and three in particular have made their way across a plethora of Robinhood investor portfolios. The most popular is ProShares Ultra VIX Short Term (NYSEMKT: UVXY), with more than 16,000 investors counting among its holdings. iPath Series B S&P 500 VIX (NYSEMKT: VXX) weighs in with almost 5,400 investors, and 3,400 other Robinhood users own shares of ProShares VIX Short-Term Futures (NYSEMKT: VIXY).
Two of these ETFs have the same investment objectives, but one is different. The regular ProShares ETF and iPath offering attempt to achieve a daily return that exactly matches the daily change in short-term futures contracts that follow the VIX. The ProShares Ultra ETF is designed to deliver leveraged performance equal to 1.5 times the daily change in VIX futures.
Volatility ETFs can work extremely well when markets fall in short periods of time. Consider this best case scenario for funds, which occurred during the coronavirus bear market:
- ProShares’ Regular Volatility ETF increased 405% from February 19 to March 18.
- The iPath fund was slightly better, up 409%.
- The leveraged ProShares Ultra ETF exploded even higher, with gains of 932%.
It’s that kind of fast payday that many new investors gravitating towards ETF volatility want to see.
Why volatility ETFs are not ideal long-term investments
The problem, of course, is that you can’t be sure exactly when that big market crash will happen. Meanwhile, volatility ETFs don’t make very good long-term investments, because they are designed with daily returns in mind.
As an example, look back two years with these three funds. With a market scare in late 2018, in addition to the COVID-19 inspired bear market, you would think it would have been a pretty good period for volatility ETFs. However, ProShares and iPath regular ETFs have declined about 3% in those two years. The ProShares Ultra ETF is down over 40%.
In other words, even with those big gains during turbulent times, volatility ETFs lost even more ground when times were good for the stock market. That left long-term investors in those ETFs with overall losses.
The best choice
Some Robinhood investors are likely trying to perfectly time a big market crash, but others will simply think that owning a volatility ETF can help you avoid the pain of stock market declines. However, that is not the best philosophy to have on your investment.
Unfortunately, volatility is the price investors pay for attractive long-term earnings in stocks. Investors should try to control and manage volatility rather than get rid of it, as eliminating risk often eliminates good returns as well.
The best option is to identify stocks of high-quality companies and buy stocks with the intention of maintaining them in the long term. In this way, you will participate in the success of companies whose businesses you understand and believe. When volatility hits and stock prices drop, having cash on hand to tap can become one of your most profitable investments.
Volatility ETFs are interesting investment vehicles for short-term traders. However, longer-term-minded Robinhood investors need to stay clear and focus more on large companies.
