If one intends to use volatility ETPs to profit from volatility, the time horizon must be very short—not much longer than a few days or weeks, in most cases. In other words, volatility ETPs are better suited for speculative purposes. The factors discussed—contango, passive management, and variance drain—make volatility ETPs a poor choice for hedging or long-term investing.
At this point, an astute investor may wonder, “If long volatility strategies have lost so much money so consistently, then why shouldn’t we flip the script? Wouldn’t a short volatility strategy mint money?”
There are short volatility ETPs available, and yes, their performance of late has been eye-popping. The fact that realized volatility has been less than implied volatility is the ideal situation for a short vol strategy. The contango phenomenon works for, not against, a short strategy.
That said, the other concerns regarding volatility plays remain true for short strategies. Short strategies are also very volatile and can lose a lot of money quickly. They are usually passively managed, so losing positions can snowball quickly, wiping out months of gains. Variance drain is very much a concern in a highly volatile product, and the impact of variance drain will be multiplied in a leveraged product. The graph below shows the price movements on the SVXY, a short volatility product.
Source: Morningstar Direct, Swan Global Investments
During the August 2015 correction, the SVXY lost over half its value in ten trading days. A short while later, the ETF again lost almost half its value between December 1st, 2015 and February 11th, 2016.