Colin Barr

Following the money in banking, economics, and Washington

Wall Street's big, fat fear-trade scam

January 6, 2011: 6:25 AM ET

Don't give in to the financial industry's fear fetish.

Everyone agrees 2011 will be a volatile one for the markets. Halting economic growth, towering debt loads and a tidal wave of free money could make for thundering swings in the prices of stocks, bonds and commodities.

Quite a hedge

But as nerve-wracking as the ride may get, ignore the temptation to sample the securities industry's latest snake oil: the exchange-traded funds and notes that track market volatility indexes.

These products sound like a good idea, as they seem to promise protection against what feels like an inevitable eruption of market chaos. Anyone not predicting a 20% stock market gain in 2011, after all, has probably spent the past year calling for a crash.

There are 10 such offerings out there now, including a half-dozen or so that have been launched in just the past few months. The most recent additions are a pair of exchange-traded funds launched this week by ProShares, though Wall Street stalwarts such as Citigroup (C) and UBS (UBS) have gotten into the act too. And why not? They handled market unrest so well the last time around.

The problem is that unless all hell breaks loose the day after tomorrow, you'll have lost so much of your money on these funds that you'd have been better off blowing it on, well, anything else.

"I would advise anyone considering buying one of the volatility futures products to dig a small hole in the backyard and set their money on fire instead," said Andrew Barber, a strategist at investment adviser Waverly Advisors in Corning, N.Y. "The net result is the same."

Consider the leader of this pack, such as it is: The iPath S&P 500 VIX Short-Term Futures exchange-traded note that trades under ticker VXX. It has returned, get this, minus 68% since it started trading in January 2009. Do not try to replicate these results at home.

The VXX is the worst offender, but its shortcomings aren't unique. Indeed, they are endemic to all the ETFs and ETNs that get exposure to an index by buying futures.

These products are apt to lose money by the bucketful when the futures markets are trading in something called contango – that is, when the near-month contract is cheaper than next-month contracts.

That arrangement punishes unwary investors because the funds that track volatility indexes do so by purchasing futures contracts, which have a set expiration date. As time marches on they sell the near-month contract before expiration and buy the next one, in a process known as rolling.

When the forward curve is in contango, it costs more to roll into the future month -- which means buying a diminishing number of new contracts with invested funds, reducing the net value of the portfolio. This feature is charmingly known as negative roll yield.

This problem is especially stark when the futures curve is sharply in contango, which it has been in recent years for the volatility indexes -- as well as for commodities such as oil and natural gas.

Persistent roll costs and fees, among other things, mean holders of these products can end up lagging behind during rallies and falling harder during declines. The Chicago Board Options Exchange volatility index, for instance, is down 12% over the past year. But the VXX, which supposedly tracks the VIX, has lost two-thirds of its value (see chart, right). This is not the best formula for protecting your nest egg.

Not keeping up with the VIXes

"When the contango is this steep, it's almost impossible to make money buying these products," said Matt Hougan, who follows ETFs for the IndexUniverse.com.

Not that poor performance and structural limitations have dimmed the allure of the VXX, mind you. Hougan says anxiety-ridden types poured $2.4 billion into the VXX in 2010.

To say that bet didn't come in is something of an understatement: At year-end, the fund's asset value was just $1.4 billion, meaning the fund vaporized at least $1 billion last year.

"It is a mark of shame to destroy that much investor capital in such a short time," said Hougan. Accordingly, his third-favorite ETF investing theme of 2011 is to "buy anything but the VXX."

Barclays (BCS), the giant British bank that sponsors this exercise in wanton wealth destruction, declines to comment on the VXX's performance. But Michael Sapir, who runs ProShares, the latest entrant into this charnel house, gamely defends the concept.

He says volatility-linked exchange-traded products can be useful for "investors seeking a negative correlation to equities, and who want to express a directional view on volatility."

Alas, this is hogwash. Barber says there is an easier way to hedge against a drop in stock prices. "An investor looking for a 'negative correlation' to indices would buy a put option and call it a day," he said.

Sapir adds, in the best tradition of those defending the indefensible, that "our product is for sophisticated investors. We don't see these types of products as being appropriate for unsophisticated investors."

You'd think the sophisticates would hardly need an ETF or ETN tied to volatility. Cool as they are, they might as well sign the appropriate forms at the CBOE and play the futures themselves, rather than paying ProShares or whoever the better part of 1% a year in expenses.

But talking about sophistication is a handy diversionary tactic if nothing else, as we saw most recently when Goldman Sachs (GS) was called on the carpet for ripping off some chumps that stumbled into its subprime debt cross hairs. When you're caught doing something that doesn't smell quite right, it just feels right to describe the fall guy as sophisticated.

And who knows. Perhaps the sophisticates really are either buying and selling these products at a rapid clip -- which is the only way they could possibly be of any use -- or, alternatively, are OK with losing two-thirds of their money. The more power to them.

If neither of those conditions describes you, you'd probably do well to swear off the exchange-traded volatility trackers. But then, that is true of so many of the exciting new products churned out nowadays by the financial industry.

"It's hard for me to imagine who would buy that product, but it isn't hard to imagine who would sell it," said Jack Bogle, the Vanguard founder who now runs the Valley Forge, Pa., mutual fund firm's financial markets research center. "I would say it's beyond my comprehension why they're selling such a thing, but I know all too well what the answer is."

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About This Author
Colin Barr
Colin Barr
Senior Writer, Fortune

Colin Barr has covered finance for Fortune.com since November 2007. Previously he was a writer and editor for TheStreet.com, winning a 2006 Society of American Business Editors and Writers award for "The Five Dumbest Things on Wall Street," and for Dow Jones Newswires. He is a 1991 graduate of Penn State and lives in Port Washington, N.Y., with his wife Meena Bose and their two kids.

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