Markets

Stephen Gandel is a Bloomberg Gadfly columnist covering equity markets. He was previously a deputy digital editor for Fortune and an economics blogger at Time. He has also covered finance and the housing market.

Investors have spent at least $2.6 billion this year on funds that are supposed to protect their portfolios in a market crash. Instead, those funds, rather than insuring their assets, have lost nearly $2.8 billion, according to data from Bloomberg Intelligence.

One of the reasons often cited for the Black Monday stock market crash 30 years ago, though disputed, is the prevalence of so-called portfolio insurance, which gave investors the ultimately false hope they wouldn't lose money when the market crashed. Volatility ETFs, the oldest of which dates back to 2009, are this bull market's portfolio insurance. The funds track the VIX volatility index, which tends to move in the opposite direction of stock prices in general.

Lower Volatility
VIX funds that were supposed to protect investors against losses have been clobbered
Source: Bloomberg Intelligence
Note: Returns are YTD through Oct. 24, 2017.

The VIX, for instance, neared 80 at the height of the market meltdown of 2008, and it spiked above 40 during the European debt worries of late 2011. But it doesn't always work that way. On Tuesday, when the Dow Jones Industrial Average rose nearly 200 points, the VIX rose as well, up 0.09 to 11.16. Nonetheless, investors have poured a net $15.5 billion into the three largest of the volatility exchange-traded products since 2009, including the $2.6 billion since December, according to Bloomberg Intelligence analyst Eric Balchunas. Of that, just $1.8 billion remains. The rest, $13.7 billion, has been incinerated by fees and the funds' poor performance.

It's not clear what percentage of investors have bought into the volatility funds for protection versus those who are simply wagering on a market decline. But the funds are marketed as hedges. ProShares, which manages three of the top five volatility funds, says one of the top reasons for buying the ETFs is to reduce portfolio risk. The fact that the market hasn't dropped has hurt the funds, of course. But making matters worse is the structure of the volatility funds, which is intended to amplify short-term moves. The result is that when the S&P 500 Index has anything more than a nice year, the volatility funds have a disaster.

For instance, while the S&P 500 is up 15 percent in this year, the iPath S&P 500 VIX Short-Term Futures Exchange Traded Note has lost two-thirds of its value. That's not as bad as the ProShares Ultra VIX Short-Term ETF, which is the second-largest volatility fund after the iPath fund and uses leverage. It's down nearly 91 percent this year. ProShares and others state in their marketing material that volatility funds are meant for traders and not long-term investors. And the funds do have a high turnover. But all that trading only increases the costs of using the funds.

Mostly Calmer Waters
Despite some spikes, volatility has turned out to be much lower than expected this year
Source: Bloomberg

The market will eventually go down and the VIX funds will eventually go up, and many investors will see the big spike and wish they, too, had the foresight to buy into the funds. Forgotten along the way will be all the money that investors poured into the funds and lost. For the top three volatility funds to repay investors all they have dumped into the fund since 2009, they would have to soar 761 percent, more than double the rise of the VIX during the financial crisis. And that's just to get back to even. Sometimes planning for the worst-case scenario ends up being just as bad.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Stephen Gandel in New York at sgandel2@bloomberg.net

To contact the editor responsible for this story:
Daniel Niemi at dniemi1@bloomberg.net