Warning: VIX Funds Nothing Like Stocks

September 15, 2014

Be careful of your assumptions (and headlines!) about volatility ETFs.

Sometimes I read something that is so dangerous I feel like I have to write a rebuttal just so I can sleep that night. This morning’s article on Bloomberg on the VelocityShares Daily Inverse VIX Short Term ETN (XIV) is one such article.

The headline of the article, “Short Sellers Fleeing Inverse VIX Fund After 24% Rally,” is confusing enough. After which rally? Certainly not the 8 percent we’ve ground out in the S&P. No, they mean the rally in XIV itself. Let’s go to the chart for context.


The center, deeply boring line is the slow, fairly steady rally in the S&P 500 SPDR (SPY | A-98). The bottom line is the crushing horribleness of the most popular volatility ETN, the iPath S&P 500 VIX Short-Term Futures ETN (VXX |A-47). The top line is XIV.

A few things to note. As we’ve mentioned here countless times, if in fact you got the calls exactly right, to load up on VXX either in the middle of January, or at the end of July, you caught a big spike in VXX as the equity markets spooked each time. And as an XIV investor, since you were investing in the opposite bet, you suffered pretty shocking short-term losses.

Doing What You’re Supposed To Do

Both of these products are doing exactly what you’d expect them to do in the short term. The biggest difference is that while VXX continues to test Zeno’s paradox with its run to zero, XIV gets to book the contango that VXX suffers as nearly guaranteed profit, month after month. Why? Because with very rare exceptions, the market always thinks things will be more volatile tomorrow than they are today, and so the curve for VIX futures always looks like this:


The curve on the left was VIX futures prices a year ago. The one on the right is today. You can consider each step up on the curve the catalyst for a happy dance among XIV investors—they get to be the ones selling high on those out-months and buying low on the nearest month.

So what’s my problem with the Bloomberg article, which seems to just be pointing out that while in June, some folks were shorting XIV, and now almost nobody is? Because it contains this outrageously dangerous line:

“The fund, with average daily volume of almost 9 million shares last week, represents a bet that is similar to owning stocks.”

This is effectively saying, “This surface-skimming rocket boat represents a means of transportation similar to floating a paper boat on a windy river.” I suppose it’s not technically entirely inaccurate, but go back and look at that chart. When you were down 25 percent in January, I doubt you consoled yourself by saying, “Well, it’s just like owning stocks; after all, they’re down 5 percent, right?”

Nothing Like Stocks

So, the first point is of course that owning XIV or VXX is nothing like owning stocks, and they’re both enormously risky instruments in their own right.

But the second question … which the article doesn’t even ask … is why anyone would be shorting an inverse fund. That’s actually the interesting question. After all, if all you were trying to speculate on was a sharp increase in volatility, then you could simply buy VXX, which is by definition the inverse bet of XIV.

The answer is “volatility capture.”

Because of the daily rebalancing inherent in any leveraged or inverse fund, XIV won’t track the inverse of VXX over the long term. Every day, if VXX loses and XIV gains, XIV will in fact have to sell a bit of its exposure, otherwise it will be overexposed tomorrow. Similarly, if VXX gains and XIV loses, XIV will have to go buy more exposure in order to deliver that -100 percent exposure tomorrow.

That constant rebalancing creates an interesting property in any leveraged or inverse fund—if the thing being tracked (in this case, VIX futures) is itself fairly placid, any rebalancing strategy will outperform a naive expectation. If the thing being tracked is itself volatile, the constant rebalancing acts as a drag on performance.

Odd Performance Patterns

This has historically created some weird performance patterns. In the worst of the financial crisis, both the levered and inverse funds tracking the financial sector did worse than the actual stocks in the financial sector when measured over a period of months, despite the fact that on any given day, they performed exactly as advertised.

In fact, just going back to the original year-to-date chart, you can see that while VXX is down 31.6 percent for the year, the inverse fund, XIV, is not up 31.6 percent, it’s up “only” 21.6 percent.

Very smart traders will sometimes use this feature of inverse ETFs to their advantage. By shorting a daily-rebalanced inverse fund, and then going long the thing being tracked, you can effectively “capture” any increase in volatility; in this case, the volatility of VIX.

In other words, the short XIV bets were from people betting that the volatility of VIX itself was going to go higher for a period of time. VIX itself might stay flat for a few months, but the path to ending flat would be rocky, and the inverse-VIX bettor would get paid for that shift.

To offset that risk, all you need to do is get some sort of countertrade—inverse volatility. Obviously, you can’t just buy XIV, since that’s what you’re shorting, but you can just short VXX—getting your inverse volatility that way. Since VXX is not levered and just promises the return of the long futures positions, you can book the volatility of VIX itself here, without any rebalancing.

Shorting Both

I’ll take a breath and repeat that: You short the Inverse VIX Futures ETN, while at the same time shorting the Long VIX Futures ETN.

What do you get for this trade? Well, in this case, year-to-date, you would have a 32 percent return from your VXX short, offset by a 22 percent loss in your XIV short, for a 10 percent gain. The entire time, you’ve had no daily exposure to actual spikes or crashes in the VIX futures themselves, because any daily spike in one would be offset by the position in the other. All you’ve done is profit from the volatility of VIX itself.

Brain hurt? Good. These kinds of volatility-capture strategies aren’t for the faint of heart, and imply some pretty sophisticated analysis and pairs trading of unlike pairs.

So the next time someone tells you a volatility product (long or short) is “just like a bet on stocks,” turn around and walk away as fast as you can.

At the time this article was written, the author held no positions in the securities mentioned. You can reach Dave Nadig at [email protected] or on Twitter @DaveNadig.

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