VIX 'fear index' makes an intriguing hedge for investors

 

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Another reason is that the fund — and most VIX funds — don't track the VIX precisely. The fund bases its returns on the futures market, and on daily returns at that. Those returns can differ significantly from the VIX itself. The costs of rolling one futures contract to another can also hurt performance.

If we overlook the fund's longer-term record, which is a bit like overlooking an ape in your bathtub, its recent history as a hedge is a bit better. The S&P 500 fell 6.3% in May, while the iPath Short-term Futures ETN soared 28.6%, according to Lipper. A 10% stake in the VIX would have reduced some of your terror.

For most people, however, VIX funds really aren't a satisfactory cure for the stock market's ups and downs. Ultimately, you have to decide how much of your portfolio you can stand to have in the market during extremely volatile times. For most people under 50, keeping at least 60% in stocks is a reasonable choice, provided you have a decade or more until you'll need your money.

What to do with the rest? Unfortunately, you have two bad choices. Normally, bonds are the diversification play of choice. But bond yields are close to record lows, and when they start to rise, bond prices will fall. And money market funds yield just 0.03%.

Cautious investors will just have to hold their noses and invest in cash or bonds. Sooner or later, money fund yields will rise — as will bond yields, which will offset some of their price declines. Until they discover a miracle cure for volatility, the old-fashioned remedies are the best.

John Waggoner is a personal finance columnist for USA TODAY. His Investing column appears Fridays. See an index of Waggoner's columns. His book, Bailout: What the Rescue of Bear Stearns and the Credit Crisis Mean for Your Investments, is available through John Wiley & Sons. John's e-mail is jwaggoner@usatoday.com. On Twitter: www.twitter.com/johnwaggoner.