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Clients who bet on or against market volatility were caught by surprise in early February, when a sharp spike in volatility futures caused dramatic swings in the value of certain exchange-traded products with underlying exposure to the Chicago Board Options Exchange’s (CBOE) volatility index (VIX). The result was trading suspensions for some products, the termination of others and at least one potential lawsuit.

The market correction demonstrated the high level of risk such volatility-tracking investment vehicles carry and the importance for financial advisors to ensure clients are educated fully on how these products work before investing.

“This episode should serve as a reminder for investors that they must be comfortable with the liquidity profile of an ETF’s underlying exposure in both calm and turbulent market environments, and not simply look at the average daily volume of the ETF itself when making an investment decision,” says David Kletz, vice president and portfolio manager with Forstrong Global Asset Management Inc. in Toronto.

On Feb. 5, the VIX surged by almost 118% to 37 from 17 in a matter of two hours of after-hours trading, recording its largest percentage gain ever. The VIX is based on the implied volatility of a basket of options on the S&P 500 composite index over the next 30 days. The price of an option rises and drops based on expectations of market price movements. A higher VIX means that traders expect the market to be more volatile during the next 30 days.

Given that the VIX is widely regarded as a “guesstimate” of market volatility, investors cannot buy shares in the VIX outright. Rather, they can invest in products such as ETFs that trade in CBOE futures contracts based on the VIX’s anticipated value.

The jump in the VIX early last month led the Investment Industry Regulatory Organization of Canada (IIROC) to halt trading of two ETFs issued by Toronto-based Horizons ETFs Management (Canada) Inc. – BetaPro S&P VIX Short-Term Futures Daily Inverse ETF (TSX symbol: HVI) and BetaPro S&P 500 VIX Short-Term Futures 2x Daily Bull ETF (TSX: HVU) – temporarily on Feb. 6 “to ensure a fair and orderly market,” as IIROC stated at the time. Horizons also suspended new subscriptions for units in both ETFs temporarily.

HVI provides exposure to the Horizons short VIX short-term futures index, which essentially is the inverse of the S&P 500 VIX short-term futures index (a theoretical rolling futures contract index), explains Mark Noble, senior vice president, sales strategy, with Horizons.

When volatility futures began to spike in after-hours trading on Feb. 5, the value of short positions dropped dramatically, leading to a loss of approximately 96% in HVI.

“No North American-listed inverse ETF that tracks volatility was spared this [precipitous drop],” says Noble, noting that some U.S.-listed ETFs suffered almost identical losses during the same period.

HVU, in contrast, takes a two times long position in VIX futures, so its gains and losses are magnified twofold. As a result, that ETF’s price spiked in correlation with the surge in the VIX.

Although HVU was not negatively affected by after-hours trading in the VIX, trading in that ETF was halted by IIROC because, says Noble, the “regulators needed to ensure that stability returned to the market prior to the resumption of trading.”

Elsewhere in the world, volatility-tracking ETFs and exchange-traded notes (ETNs) experienced various levels of losses and gains as a result of the spike in volatility. In the case of Switzerland-based Credit Suisse AG‘s Velocity Shares Daily Inverse VIX Short-Term Exchange Traded Note (NASDAQ symbol: XIV), the losses were so severe that the product was delisted.

Based on XIV’s prospectus, if the value of the ETN is equal to or less than 20% of the prior day’s closing value, an “acceleration event” is triggered and XIV would be liquidated. The value of the ETN had dropped by 93% in after-hours trading on Feb. 5. As a result, NASDAQ suspended trading on XIV and subsequently delisted it.

Nomura Europe Finance NV also announced the early redemption of Next Notes S&P 500 VIX Short-Term Futures Inverse Daily Excess Return Index ETN, listed on the Tokyo Stock Exchange, as a result of similar sharp losses.

“This was not a case of ETFs ‘misbehaving’ or the ETF structure breaking down. In reality, these products did what they were supposed to do,” says Kletz. “The underlying derivatives exposures of these ETFs are reset on a daily basis – some are leveraged up to three times – which means that sharp volatility spikes can cause outsized losses.”

Kletz suggests that “volatility ETFs represent yet another tool for investors to modify the risk factor exposures and tactically position their portfolios. [These ETFs] are meant to be daily trading vehicles, not ‘buy and hold’ investments.”

Investor education is vital for these products, Kletz adds. In fact, lack of education is the subject of an investigation into XIV by Klayman & Toskes PA, a Florida-based arbitration law firm, on the grounds that “recommended investments in these securities were unsuitable for many investors who did not understand the risks associated with the investment strategy, which were not adequately disclosed.”

Despite the risks volatility-tracking ETFs carry, they have become very popular – especially in the U.S. Says Kletz: “ETFs based on the VIX – both long and short – have become highly popular and attracted billions of dollars of inflows. The subdued market environment in recent years has contributed to the appeal of short volatility ETFs, in particular.”

However, Kletz adds: “With significant differences to typical buy-and-hold investments, volatility ETFs generally are better suited for experienced investors who have a firm grasp on how they are constructed and behave.”

The products are not intended for cautious investors, Noble adds: “HVI and HVU are speculative investments and are, by nature, very volatile. They’re appropriate for [investors] trying to profit or speculate on swings in volatility.”

Clients who are looking to reduce volatility in their portfolios should be looking for ways of reducing risk, Noble says: “There are numerous ways to do this, whether it’s buying puts; more conservative investments, such as lower-beta stocks or government bonds, which historically have lower volatility; or even increasing levels of cash.”

Heather Holjevac, senior wealth advisor with TriDelta Financial Partners Inc. in Oakville, Ont., says “managing volatility and risk is all about managing expectations.”

Specifically, she says, you can help your clients manage risk with traditional investment products, without having to invest in volatility-based products.