With two thirds of 2012 in the books, the year is on track to be a relatively solid stretch for most investors. Despite an abundance of potential land mines and significant challenges, such as stubbornly high unemployment, general uncertainty over the future of the Euro zone, and a “fiscal cliff” on the horizon, stocks have generally continued their upward climb that began when markets bottomed out about three and a half years ago.
Broad-based stock ETFs like the S&P 500 SPDR (SPY) are firmly in positive territory for the year, while the tech-heavy PowerShares QQQ has posted even more impressive gains thanks to a red hot tech sector. Certain corners of the market have been quietly posting some impressive performances; some homebuilder ETFs have gained close to 50%, while many biotech ETFs have added 30% or more [see the 100 best and 100 worst ETF performers of 2012]. But the biggest winners so far in 2012 have been exchange-traded products that deliver inverse exposure to an index comprised of VIX futures contracts–essentially allowing investors to sell a form of “portfolio insurance.” Three inverse VIX ETFs and ETNs have added more than 100% so far in 2012, making them by far the best performers from the universe of more than 1,400 exchange-traded products:
- VelocityShares Daily Inverse VIX Short-Term Futures ETN (XIV, up 112%): This exchange-traded note offers daily inverse exposure to the S&P 500 Short Term Futures Index, a benchmark that includes short-term VIX futures contracts.
- ProShares Short VIX Short Term Futures ETF (SVXY, Up 110%): This product is very similar to XIV, but structured as a true ETF as opposed to an ETN. That means that SVXY doesn’t include credit risk, but can potentially experience tracking error. It’s also worth noting that there may be some unique tax treatments between the two products.
- ETRACS Daily Short 1-Month S&P 500 VIX Futures ETN (AAVX, up 107%): This ETN is part of a suite of products from UBS that offer inverse exposure to VIX futuress, focusing specifically on one month contracts.
Inside The Inverse VIX Strategy
Inverse VIX ETPs generally seek to deliver returns that correspond to -100% of the movements of indexes consisting of VIX futures contracts. The VIX tends to spike when stock markets crumble (and vice versa), giving it appeal as a negatively correlated asset that can protect investors during times of turbulence. Inverse strategies, on the other hand, tend to exhibit a very strong correlation to global stock markets–through with considerably more risk on both the upside and the downside. XIV, for example, has a beta of greater than 4.0.
The stellar performance from these ETFs and ETNs is attributable in part to a decline in expected stock market volatility as measured by the VIX (also known as the “fear index”). The VIX opened 2012 at a level of about 23, and had declined to about 17 by late August. That’s a substantial decline–nearly 30%–but still obviously accounts for only a portion of the massive returns. The bulk of the gains from these products is attributable to the steep and consistent contango in VIX futures markets–the phenomenon whereby futures contracts are upwards sloping, with those expiring in the future being considerably more expensive than the spot VIX. This has been likened to the “premium” on an insurance policy–it’s the price investors pay for protection in the event of a disaster [see 101 Lessons Every Financial Advisor Should Learn].
Buyer Beware: Lessons From August 2011
Along with the opportunity for massive returns from these products comes some fairly substantial risk. XIV, which debuted in late 2010, enjoyed a red hot start to 2011 as well; through the first half of the year, it had added almost 60%. But when stocks suddenly tumbled in the third quarter, XIV took a nosedive and lost about 60% in a matter of two months. By early October, it had dropped nearly 75% from its 2011 high.
Disclosure: Long XIV.
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