As many market participants have learned the hard way, it is expensive to buy and hold a long position in VIX futures, options or exchange-traded products. Simply looking at the return of the index makes that painfully clear. The return on the indexes, especially the short-term index, has trended down since inception. The relative performance of the indexes is even clearer when looking at the numbers (see Figure 7).
The S&P 500 VIX futures short-term and midterm indexes are the reference indexes for almost all of the outstanding VIX-related ETPs. Some are leveraged, periodically resetting and/or comprise a combination of indexes. It is important to understand how the index underlying the ETP behaves under different market conditions, and equally important to understand the instrument. One area that has received a great deal of attention is the performance of leveraged and inverse products that reset daily, and that is particularly interesting in the context of VIX futures indexes.
Daily Resetting Leveraged And Inverse Products
Daily resetting leveraged and inverse products have return characteristics that may not be immediately apparent to many investors. These instruments seek to replicate the performance of a leveraged or inverse position in an underlying index for a one-day holding period. In general, these types of instruments are suited for professional traders who are interested in using them to express specific short-term market views or manage portfolio risk. They are not intended for buy-and-hold investors.
In most cases, the performance of a daily rebalancing leveraged or inverse instrument held for more than one day will be different than a similar instrument that is not rebalanced. In fact, for holding periods longer than a day, it is possible for leveraged/inverse products to perform in the opposite direction than would be expected given the performance of the underlying index. For example, the under-lying index could have a positive return, while the leveraged instrument could have a negative return. This is especially true in choppy markets. This loss of value resulting from daily resetting is frequently referred to as “decay.”
The daily resetting instruments exhibit positive convexity—the returns of the instrument increase more rapidly and decrease less rapidly than an equivalent linear exposure. As an example, in Exhibit A of Figure 8, the exposure increased on day 2, and this is the reason the daily rebalanced position outperformed the nonrebalanced position by 2 percent.