With some inverse VIX Exchange Traded Products (ETPs) gaining more than 80% in 2016, interest in VIX linked investing is perhaps unsurprisingly growing quickly. At the time of writing this article (May 25, 2017), the popular VelocityShares Daily Inverse VIX Short-Term ETN (NASDAQ:XIV ) was up more than 60% since the start of the year.

Of course, with these kinds of returns usually comes substantial risk, and continued profit from a passively managed exchange traded product like the XIV relies on recent market conditions persisting - that is to say, the continuation of steadily rallying equity markets and low implied and realized volatility.

But what if these conditions don't persist, what then? Well, as market volatility rises, these passively managed inverse VIX ETPs are likely to lose considerable value, possibly retracing this year's gains - or worse! For example, a 50% single day increase in the value of an inverse VIX ETP's portfolio - say a jump from a value of 12 to 18 in the VIX futures - would likely half the value of the ETP, and put a significant dent in any accumulated gains. Even worse, a single day jump of 100% in the ETP's portfolio - say an increase in futures prices from 12 to 24 - would wipe out the inverse ETPs altogether. This is why few would ever recommend an inverse VIX ETP as a sensible 'buy and hold' investment.

To be fair the sponsors of inverse VIX products disclose this fact quite explicitly in their prospectuses. VelocityShares, for example, points out at the top of page 16 of the XIV prospectus that 'The long term expected value of your ETNs is zero. If you hold your ETNs as a long term investment, it is likely that you will lose all or a substantial portion of your investment.'[1] An ominous warning indeed.

So if one was considering investing in an inverse volatility product, how can some of this risk be mitigated? Well, some have argued that a small permanent holding of maybe 5-10% of a portfolio could allow investors to access the ETP's returns without putting too much capital at risk.[2] Tony Cooper for example, in his seminal paper on the topic proposed a portfolio of 55% equities, 35% bonds, and 10% volatility products to help boost performance while managing the scale of any potential drawdown from the volatility component. He went on to point out that the 'more aggressive equity investors may wish to increase the volatility proportion even higher.'[3]

But Cooper also points out four competing approaches that he believes might outperform this passive 'buy and hold' of inverse volatility products - strategies he categorizes as 'Momentum', 'Roll Yield', 'Volatility Risk Premium', and 'Hedged'. While I won't go into the details of Cooper's strategies, I do encourage you to read his paper and I have included a link to it in this article's footnotes.

And this brings me to the main point of this article. If VIX ETPs are to form part of a longer term investment strategy, how is an investor to act in light of warnings like that posited by VelocityShares above? One way is to follow Cooper's advice and implement one of his proposed active strategies by buying and selling the ETPs at opportune moments. This of course makes sense - selling an inverse VIX ETP before a significant market drawdown and then buying it back days later would improve returns and potentially limit some of the inherent risk.

But managing these strategies can be complicated and time-consuming. Backtests of Cooper's 'Hedged' strategy for example required trades every single day, and the time commitment needed to consistently implement that type of trading is probably well beyond most investor's capability.

So how can the average investor access active strategies that look to benefit from inverse VIX ETPs? One way could be to buy trading signals from one of the leading volatility strategists and implement their proprietary approach to maximizing long term gains by attempting to avoid large drawdowns. But again, this works well for active traders but the day to day trading needed to implement the strategies is probably too time consuming for the average investor. Furthermore, with so many strategists offering so many different strategies, how can the average investor be sure they'll be in the best hands?

Another approach is to open an account with a Registered Investment Advisor (RIA) that specializes in VIX products and let them manage a strategy for you. Invest In Vol is the first volatility focused RIA to offer multi-strategist accounts from the three leading volatility strategists. Because no two volatility strategies are the same, diversification across three strategies could improve risk-adjusted returns, mitigate drawdowns, and avoid single strategist risk. Furthermore, implementation of a balanced volatility strategy by a specialist RIA in a Separately Managed Account (SMA) turns a time-consuming trading strategy into a long term investment, allowing the average investor to finally benefit from the potential diversification of volatility as an investable asset.

Footnotes

[1] VelocityShares (2016) Prospectus. August 9, 2016

[2] Cooper, T. (2013) Simple Volatility Investing. SSRN.

[3] Ibid, pg. 28.