Volitility ETFs – Profiting from a crisis

28th November 2011

Of course, investors could just short-sell, but this brings high risks in a climate of extreme volatility. After all, if there is a hint of good news from the wider economy, markets could move up very fast. A more creative approach would be to find those investments that actively profit from volatility or difficulties.

The first volatility ETF launched in Europe earlier this year. Could this be a solution? In theory, this should work well. An investor profits not from the movement up or down in the equity market, but from the level of volatility as measured by, in most cases, the Vix index. Investors win when there is lots of volatility, either up or down, and lose when markets are stable. As such it provides a hedge for uncertainty. There are now around 30 of these products in the US and the first one launched on the German exchange in May.

However, volatility ETFs haven't always had the best press

"The prices of these ETNs (exchange-traded notes) have had a natural downward trajectory for three reasons: First, the much-publicized problem of tracking error being compounded on a daily basis will cause these to underperform the VIX. The longer the time frame, the greater the underperformance. Second, the fact that the ETNs have to roll from month to month in VIX futures means that they give up a premium by rolling out of the expiring contract and move into the higher-priced, longer-dated contract each month. Third, of course, is the issue of expense ratios."

But there are signs that the sector is trying to improve. This piece assesses a new strategic volatility ETF and proposes an alternative strategy:

However, volatility ETFs – however imperfect a solution – are just one example of how every disaster has its flipside. This Wall Street Journal article from last year shows that there are always some companies benefiting from difficulties.

Water is a good example. Barrie Harrop says in response to the above article: "Growing competition for scarce water resources is a growing business risk, a major economic threat, and a challenge for the sustainability of communities and the ecosystems upon which they rely. It is an issue that has serious implications for the stability of countries in which businesses operate, and for industries whose value chains are exposed to water scarcity." Companies that address that problem stand to be extremely profitable. The same is true of companies that address energy or health needs

Healthcare companies are well poised to benefit from disasters, as this article on Public Citizen points out.

"What about profiting from pandemics, worldwide epidemics of infectious diseases? Altucher noted that every year the strain of flu virus changes and vaccines created the previous year to combat the virus can be ineffective. Should a more serious pandemic arise, stocks that would possibly profit include GlaxoSmithKline, the largest manufacturer of flu vaccines, as well as Sanofi-Aventis. Another company that could profit from such an outbreak is Alpha Pro Tech, maker of masks that protect against airborne contagions."

The issue of catastrophe bonds has already been discussed on Mindful Money here and offers another way to profit from disaster.

But on this site Kaitlin Wright expresses the view of many saying: "Catastrophe bonds are a very interesting concept. Investing in a cause like this raises many ethical questions. Just because you can profit off of something, doesn't mean you should – especially if that something is destruction and death of a city." However, it is worth considering the opposite scenario. What if capital were drained away from these companies, leaving them not in a position to help in a crisis?

With ‘crisis' now the norm, finding a way to profit from it may be a protective strategy for portfolios over the long term.

 

More from Mindful Money: 

Profiting from disaster? Catastrophe Bonds

Volatility: looking for the philosopher’s stone

Market crash: The secret to investment timing

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