2 Cheers For Volatility-Play XIV, But Only 2

The inverse volatility ETN eclipsed its plain-vanilla rival VXX in assets recently. What does this mean?

Every year at the Inside ETFs conference in Florida, someone trots out the miserable long-term return profile belonging to the iPath S&P 500 Short-Term Futures ETN (VXX | A-54).

By now, anyone who’s been within shouting distance of ETF.com knows that VXX is large and liquid tactical play on volatility that will eat your lunch, your dinner and everything in your cupboard—if you hold it for the long run. And they know that that long-term negative returns stem from massive roll costs due to a persistent upward-sloping VIX futures curve.

When people see the long-term performance for VXX (Bloomberg IV Index 2/13/13 to 2/13/14), the first response is often “who’s taking the other side of this trade?”

In fact products like the VelocityShares Daily Inverse VIX Short Term ETN (XIV) and the ProShares Short VIX Short-Term Futures ETF (SVXY) have been doing just that for years. XIV made headlines in our nerdy world earlier this week when its AUM peaked above that of VXX.

What do we know about XIV? Well, it walloped VXX over the past 12 months with a 42.9 percent return versus VXX’s -52.5 percent (based on Bloomberg IV Index 2/13/13 to 2/13/14). It benefits from the same VIX futures term structure that punishes VXX.

The fact that XIV didn’t return positive 52.5 percent—the inverse of VXX’s return—can be chalked up to an underlying return pattern that’s defined by choppiness and reversals. (See Elisabeth Kashner’s clear description of path dependency issues.)

Here’s a chart of naive returns—the literal inverse of VXX’s returns versus XIV’s actual performance per Bloomberg data.

(Charts based on closing indicative values provided by Bloomberg.)

Yes, XIV aligns poorly with long-term naïve inverse VXX performance. Big deal. As noted above, these are trader’s tools. They’re held for a day, not a year. (VXX and XIV literally trade close to their entire AUM on a daily basis.) The fact that XIV doesn’t mirror VXX makes it an imperfect short-run tool, not a useless one.

The people I spoke with in Florida last month who are using volatility products—whether ETNs, ETFs, futures or options—commented that inverse vol exposure is often a key tool for their short-term vol trades.

I don’t claim to fully understand, much less believe, in the strategies, but the basic idea of offsetting the roll cost of long vol exposure with short vol exposure isn’t hard to grasp. The combo of long and short vol exposure is akin to a long straddle position using options—betting on volatility without calling the direction.

So XIV and SVXY are imperfect but liquid inverse tools that help vol traders to do their thing, whether that means pure speculation or short-term equity hedging.

Why two cheers instead of three? Unlike the judges of wintry jumps in Sochi, I’m penalizing rather than rewarding based on the degree of difficulty.

As the chart above shows, XIV itself is extremely volatile (and a bit more volatile than VXX), a trait that might appeal to traders but still amps up the risk even in the short run. Convexity, as well as the volatility of volatility, is often cited in geared volatility strategies, and maybe I’ll blog on that someday when I have 40 hours or so to kill.

Until then, plan on doing a heap of due diligence before wading in here. Or, if you’re a hip shooter, fire away, but recall that most players—for both XIV and VXX—measure their investment horizon in hours, not years.

At the time this article was written, the author held no positions in the securities mentioned. Contact Paul Britt at [email protected].