Investors are flocking to exchange-traded products (ETPs), wagering that market volatility will rise from its current extremely low levels. However, while they await significant volatility spikes for profits, a special market mechanism is continuously eroding their returns.

The largest product tracking Cboe Volatility Index (VIX) futures performance - the Barclays iPath S&P 500 VIX Short-Term Futures Exchange Traded Note (ETN) - has seen its assets under management grow over 300% this year, surpassing $1 billion. The appeal of these products lies in their potential for substantial returns if the current record-breaking stock market rally fades and market volatility surges.

However, these securities harbor traps for investors who hold them too long: when traders expect future market volatility to exceed current levels, these products continuously consume capital. As more funds pour in, the erosive effects of these holding costs become increasingly severe.

Bloomberg Intelligence senior ETF analyst Eric Balchunas compares VIX-related ETPs to "chainsaws" - highly effective for specific scenarios, "but they can also saw off your own arm."

These products promise investors substantial returns if the VIX index soars. With proper timing, significant profits are possible. For instance, if investors had bought the "Volatility Shares 2x VIX Short-Term Futures ETF" on April 1st before major US tariff increases and sold on April 8th, they could have doubled their money.

However, achieving such returns requires precise entry and exit timing. Compiled data shows that holding the fund continuously over the past year would have resulted in losses of up to 78%.

"These products can see dramatic price increases, resembling options but without expiration dates. Therefore, even if the expected market correction or decline doesn't occur before option expiration, you can continue holding these 'long volatility' ETP shares," says Michael Thompson, co-portfolio manager at Little Harbor Advisors.

For long-only investors, these tools provide convenient hedging - after all, volatility indicators typically rise when the S&P 500 declines. Unlike 2018, when speculative capital flooded "short VIX" products, triggering what became known as "Volmageddon," this influx of hedging capital is not expected to disrupt markets.

Rocky Fishman, founder of research firm Asym 500, notes that retail traders "want to adopt cautious, protective strategies." He estimates that VIX-related ETPs currently hold approximately 40% of VIX futures open interest.

But the costs of holding these instruments are significant. Take UVIX (a VIX-related ETF) as an example - it has a disclosed expense ratio of 2.8% and currently holds two VIX futures contracts expiring in October and November. The fund daily sells portions of October contracts and buys November contracts until October contracts expire; subsequently, November contract holdings gradually shift to December contracts, and so forth.

Since October contracts trade below November prices, the fund essentially "sells low and buys high," continuously consuming capital. Worse still, this contract rolling operation further depresses near-month futures prices while increasing costs for next-month futures positions.

Matthew Thompson, Michael Thompson's brother and co-portfolio manager, explains: "To maintain a 30-day weighted expiration, they must daily sell near-month contracts and buy next-month contracts. This inevitably widens the spread between the two nearest contracts, which ironically further increases holding costs for these instruments."

These ETPs aren't the first products to encounter contract rolling issues. Over a decade ago, retail investors heavily invested in the United States Oil Fund ETF attempting to track oil price gains, ultimately earning returns far below crude oil spot price increases.

As stock markets steadily rise, implied volatility (the market's best estimate of future price movement magnitude) remains largely suppressed. The core reason is that recent actual market volatility has been small - when recent trends show low probability of significant price movements, traders are unwilling to pay high prices for options betting on volatility.

This phenomenon is particularly pronounced in short-term volatility, with the S&P 500's trading range consistently narrowing. This keeps short-term option implied volatility low, subsequently depressing both VIX spot index and near-month futures prices.

Société Générale strategists have proposed arbitrage strategies exploiting the futures curve's "deep backwardation." In their Thursday report, they note that the current VIX futures curve is not only in contango but exhibits a "concave" characteristic - the closer to expiration, the steeper the curve slope.

These trading strategies essentially short the near end of the VIX curve, such as selling near-month futures while buying next-month futures. The rationale is that as expiration approaches, near-month futures typically decline more than next-month futures.

Of course, these trades carry risks. Strategists including Brian Fleming and Kunal Thakkar emphasize that "the main risk is severe and turbulent stock market declines, which would cause the VIX curve to shift significantly higher and invert substantially."

For investors hoping to hedge potential portfolio losses from stock market declines, they may be less sensitive to "capital drain" than retail investors. This demand could continue driving fund inflows to these products.

Additionally, Robert Harlow, vice president of global multi-asset research at T. Rowe Price Group Inc., notes that hedge funds also use these products, particularly for short-term trading. He points out: "For macro hedge funds not equipped with various options trading infrastructure, these products are operationally simple - just 'get in, get out.'"