VXX And The Black Hole Club

March 17, 2011

For those anticipating a rise in equity market volatility, it’s been a long wait. Unfortunately, investing in Barclays Capital’s iPath short-term volatility exchange-traded note (VXX) hasn’t been the way to play it.

VXX – along with most double- and triple-leveraged exchange-traded products and contango-contaminated commodity trackers – is a member of the least-select industry grouping, the black hole club.

To join the club, you have to be worth less than the cumulative cash inflows given by your investors since you were set up. Imagine bucketfuls of water being poured into a leaky container and you’ll get the idea.

Whether you make it into the club is – as in real life – the result of an unpredictable mixture of design and accident. Leveraged ETFs are in there by design – it’s practically impossible to own them for any length of time without losing money. For investors in volatility and commodity trackers, the long-term return you achieve depends both on spot price movements and on the shape of the futures curve. If you’re having to pay a premium each month to roll positions forward (if futures are in contango, in other words) you’re almost certain to get in.

Unfortunately for investors in VXX, and for investors in many energy trackers, it’s been contango all the way for the last two years. Add in a steady decline in spot volatility since early 2009 and the resulting performance of VXX has been appalling: the ETN lost 68.4% in 2009 and another 74.6% in 2010.

But, amazingly, all this hasn’t stopped VXX from registering in the top ten US ETPs by cash inflows for each of the last two years (with US$1 billion of inflows in 2009 and over US$2.5 billion last year).

There’s no shortage of uninformed investors, or of people believing that they can get in and out of VXX in time, it appears.

Just how nimble you need to be can be shown by comparing two charts.

If you look at the performance of VXX and “spot” VIX since year-end, you’ll see that a rise of nearly 70% in the spot volatility indicator so far in 2011 hasn’t helped VXX at all. You’ve barely broken even over the year to date, in fact: contango – the cost of rolling those futures forward – has eaten away all the rise in the VIX index.

EU_VXXAndTheBlackHoleClub_03172011

Rebasing the change in VIX and VXX to the most recent trough in equity market volatility (VIX closed at 15.69 on 11 February, and has risen nearly 90% since then, registering 29.4 at last night’s close), you’ll see that investors in VXX have had some joy over the last month and a bit, with a rise of just over 30%. Note that, even if you had your timing spot on and bought VXX at the volatility trough, you’ve only earned around 40% of the rise in the spot VIX indicator since then.

EU_VXXAndTheBlackHoleClub_03172011_2

If you were seeking evidence to back up Vanguard founder John Bogle’s assertion, made during a webinar on IndexUniverse nearly two years ago, that “we have evidence—strong evidence—that exchange-traded funds, because of the timing that goes on in them, are not acting in the best interest of investors; or, that investors are not acting in their own best interests, which may be a better way to put it” you wouldn’t have to look beyond the black hole club.

 

 

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