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Careful, This ETF Returned 167% In 2 Years

Dave Nadig

On Tuesday, we did the latest session in our ETF University Series. The topic was alternatives ETFs, and so we had the obligatory section on volatility investing. After all, of the $4 billion invested in alternative ETFs, $2.6 billion is invested in products tracking some form of volatility.

So of course I put up the chart I use in almost every ETF presentation I ever do:the glorious since-inception chart of the largest ETF in the space, the iPath S&P 500 VIX Short Term Futures ETN (VXX | A-47):

VXX

Chart courtesy of Bloomberg

Born on my birthday in 2009, this amazing feat of financial engineering has lost 99.5 percent of its initial value.

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There’s nothing nefarious going on, the problem is just the crippling contango in VIX futures, a market that volatility ETFs occasionally own all of. With very few exceptions, the market for VIX tomorrow has always been more expensive than the market for VIX today, so the roll of VIX futures is almost always “buy high and sell low,” which even my 10-year-old knows is a recipe for losing a lot of money.

The chart below shows the current shape of the curve for VIX futures (in blue) and the same curve a year ago (in gold).

VIX_Contango

Chart courtesy of Bloomberg

But then someone asked the smart question in our webinar, If VXX is such a guaranteed money loser over the long term, why hasn’t anyone ever done the opposite? Wouldn’t that just print money?

 

It’s a great question, and the answer is:Someone did. The product is the VelocityShares Daily Inverse VIX Short Term ETN (XIV). As the name suggests, it’s a daily-resetting inverse fund keyed to the very same index tracked by VXX. Launched 22 months to the day after VIX, the fund has returned 288 percent since, while VXX is down 95 percent. In just the past two years, it’s up 167 percent, while VXX is down 82 percent.

XIV

Chart courtesy of Bloomberg

The fund’s done well in gathering assets too, and now sits at $776 million—not bad for an ETN in an obscure corner of the market. So why isn’t my entire retirement account invested in XIV? A few reasons:

  1. It’s expensive as all get-out. At 1.35 percent, it’s in rarified territory as far as costs go.
  2. Over short-term periods, the fund will actually do significantly worse than you expect.

The second one’s a doozy. As a daily-reset inverse fund, it suffers from the same compounding math that plagues all levered and inverse funds—something we covered in our webinar this week as well. Here’s the slide we used to explain how it works:

ResetMath

In this example, we’re imagining a -2X fund, not a -1X fund like XIV, but the principle is the same.

 

Each day, the fund resets its exposure so that when the market opens, XIV will go down exactly as much as VXX goes up or vice versa—that day. The result of all that daily rebalancing is that even over as short a holding period as a few days, your actual returns won’t look like a perfect mirror image of VXX. The more volatile the index tracked, the more punishing this math is (underperforming).

If the index tracked is trending and low-volatility, it works in your favor, and the daily resets actually give you outperformance.

Unfortunately, the very nature of how the VIX index tends to perform ensures that when things go wrong, they go wrong with a lot of volatility. That leads to periods like the past few weeks, where XIV has done significantly worse than a naive “negative VIX” return might suggest:

XIV_July

Chart courtesy of Bloomberg

You would expect XIV to “only” be down 10.5 percent in this period, but in fact, it’s down 13.4 percent. That’s a 3 percent slip in just a few weeks, not because of anything wrong with the product—it’s doing exactly what it’s supposed to do—but just because of the math.

It’s also important to realize that should we face a significant market correction, or even a period of significant uncertainty, VIX will spike, and VXX will go up significantly in a short period of time. Imagine you’d been in XIV during the fourth quarter of 2008:

 

VIX_2008

Chart courtesy of Bloomberg

Thanks to daily resetting, you wouldn’t have literally lost 200 percent of your investment as the VIX short-term futures index went up 200 percent; let’s just say it would have been very, very bad.

And that’s what keeps me out of products like XIV. Long term, it’s got market structure on its side. But short term? I don’t think I could stomach how it will perform when the VIX hits the fan.

At the time this article was written, the author held no positions in the securities mentioned. Contact Dave Nadig at dnadig@etf.com.


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