Although stocks have been weak as of late, broad market investing has still been quite profitable from a year-to-date look. In fact, even with the recent slump, the S&P 500 is still up double digits so far this year, marking a huge turnaround from last year’s flat performance.
Yet, obviously when one delves deeper into the performance picture, there are both outperforming as well as disappointing market segments in the time period in question. For example, energy and utilities have lagged, while consumer discretionary and financials have the way higher for the market so far in 2012 (see Five Best ETFs over the Past Five Years).
Beyond these stocks, investors have also seen some solid performances in various other investing segments, many of which are overlooked. In this regard, emerging markets have been solid performers while a few commodities and bond products have also put up impressive gains in the time frame as well.
However, outside of the usual suspects, there is one relatively new exchange-traded segment that has provided many investors with truly remarkable gains, volatility. Yet not just any type of volatility purchase did well in this environment, but rather an investment in inverse volatility ETFs has been the key to unbeatable gains so far this year (read Guide to the 10 Most Popular Leveraged ETFs).
Inverse Volatility ETFs Explained
Currently, there are two products in this segment, the VelocityShares Daily Inverse VIX Short Term ETN (XIV) and the ProShares Short VIX Short-Term Futures ETF (SVXY). While the two aren’t exactly the same—though they have similar strategies for targeting the inverse return of volatility—they have both put up truly incredible returns in the YTD time frame with both adding more than 140% since the start of the year.
How Can This Be?
While markets were moderately volatile in the year to date period, the actual reading on the VIX index didn’t increase that much. In fact, the VIX traded in a relatively narrow range, briefly flashing above 25 before falling to its current level in the high teens.
Obviously, a reduction in volatility is great news for products that are tracking the inverse return of volatility, albeit on a daily basis. However, the clear trend in the VIX makes the return compounding, something that is a key feature of daily rebalancing ETFs and ETNs, boost returns over long time periods. Due to this compounding and deep trends for volatility, XIV and SVXY have been nearly unstoppable since the 2012 high of the VIX in early June (read 3 ETFs to Prepare for the Fiscal Cliff).
If that wasn’t enough, inverse volatility also benefits from what is known as ‘backwardation’. That is because, generally speaking, the VIX is in a state of heavy contango, or in other words, futures further out along the curve have a higher price.
This means that products which are cycling into VIX futures must always buy a more expensive contract, a situation which creates a huge headwind to any long term performance. Fortunately, short VIX products can take advantage of the reverse of this trend, benefiting from volatility’s troubles and turning them into profits (read Understanding Leveraged ETFs).
This has certainly been the case for both XIV and SVXY over the past few quarters and especially since the top for the VIX in June. In fact, these two products have both added over 70% since the start of Q2, even with the recent bump up in volatility which has hurt their overall return.
However, with that being said, investors should note that XIV and SVXY are by no means guaranteed to gain and that VIX futures aren’t always in contango. For example, in late July and early August of 2011 inverse volatility was a pretty terrible investment while ‘regular’ volatility products, like VXX, were stars, earning their keep in that difficult time (read 4 Low Volatility ETFs to Hedge Your Portfolio).
Still, besides when the market is absolutely crashing, inverse volatility seems like a decent opportunity due to the trends in the volatility market, and the usual curve of the VIX futures market which only adds to their gains potential. So for those investors who believe that this trend can continue, we have highlighted some of the key differences between the two inverse volatility ETFs below.
Just note that both utilize a daily rebalancing methodology and are not really designed for long-term holdings. After all, the volatility of volatility can be quite high during uncertain market environments, but if stocks are stable either of XIV or SVXY could be interesting picks for a small portion of a well diversified portfolio:
Volume (per day)
ETF or ETN?
ETN- no tracking error, credit risk
ETF- no credit risk, tracking error
Author is long XIV.
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